CHAPTER II

LITERATURE REVIEW

2.1 Fundamental Analysis

To estimate the fair value of one company’s stock requires a

forecast regarding earnings or dividends. “Fundamentals are charateristics of a

company related to profitability,financial strength, or risk” (Pinto, et Al. 2010).

Fundamental analysis is one method which evaluate securities in order to measure the

intrinsic value such as earnings and dividend in regard of economic, financial, and

other related quantitative and qualitative factors. Fundamental analysis examine

related factors which affect the securities including macro economic factor such as

gross domestic production growth industry analysis such as typical lie cycle of an

industry to specific factors in the perspective of a company such as financial

condition and management (Bodie et Al, 2009). This approach commonly stated as

top-down approach since its initially started with wide perspective then it narrowed

down to the specific firm factors. The purpose of conducting fundamental anaylsis is

to evaluate the value which could be compared with market price, then considered as

underpriced or overpriced.

9
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2.2 Intrinsic Value

Value is one critical assumption in regard of equity valuation. One

publicly traded securities market value could be different from the the intrinsic value

of the securities.“The intrinsic value of any asset is the value of the asset given a

hypothetically complete understanding of the asset’s investment charateristics. For

any particular investor, an estimate of intrinsic value reflects his or her view of the

“true” or “real” value of an asset” (Pinto et Al, 2010). If one consider market value as

perfect reflection of intrinsic value, the idea of valuation is simply by refering to the

market value. In general it is the basic of traditional efficient market theory, which

argues that market price is the best estimation of its intrinsic value. An important

theoritical counter to the idea that market price perfectly reflect its intrinsic value is

stated in the Grossman-Stiglitz paradox. (Grossman and Stiglitz, 1980) argues the

investors will not afford the effort of gathering information unless they are

compensated with higher gross return compared by simply refering to the market

value as intrinsic value. Furthermore, how would the market price reflect the

securitiy’s intrinsic value in the first place if the existence of investors whom seek to

analyze and gather information is none. (Lee, Myers, and Swaminathan, 1999)

recognize that the intrinsic value is difficult to be estimated as in matters of common

stock, and when transaction fee exist, it will creates room for market price to differ

from its intrinsic value.

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2.2.1 Going-Concern Value and Liquidation Value

The value of a company if its immidiately dissolved is differ from

the value of one company that will continue operating in the future. In equity

valuation going concern assumption is utilized. Going concern assumption assumes

that one valuation object is to be continuing its business activity of producing, selling,

and utilize its assets in valuable manner in period of foreseeable future. Going

concern assumption is not applicable if the company is under heavy risk of

bankruptcy. Thus, in alter there is one known as liquidation value. Liquidation value

apply when one company unable to proceed with its business activity and dissolved

by selling assets in individual manner.

2.2.2 Fair Market Value and Investment Value

Intrinsic value perhaps is the highlight of an analyst, however the

value itself in some case are relevant. There is two assesment which involves the

value of an assets, which are fair market value and investment value. “Fair market

value is the price at which an asset (or liability) would change hands between a

willing buyer and a willing seller when the former is not under any compulsion to

buy and the latter not under any compulsion to sell” (Pinto et Al, 2010). On other

perspective, investment value consider one different concept of value due to potential

synergy is involved. One specific buyer of a company will have different paradigm of
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value if the buyer have different expected return because of the potential synergy

which might be gained.

2.3 Valuation Process

(Pinto et Al, 2010) states three general valuation steps which

involves understanding the business, forecasting company performance, selecting the

appropriate valuation model, converting forecast to a valuation, and the last is

applying the valuation conclusion.

2.3.1 Understanding the Business

To conduct a robust forecust regarding company’s future

performance and narrowed down to the value of an investment in the company, it is

significant to comprehend the macro economic and industrial context which the

company involved in. Macro economic analysis, industry and competitive analysis,

combined with the analysis of financial reports becomes an important cornerstone for

forecasting and valuation. The common perspective of valuation is top-down

approach which initially started with larger point of view than narrow it down to the

company specific issues, in alter is the bottom-up approach which is simply the

reverse.
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Source: Presentation material of Pardomuan Sihombing (2010)

Figure 2.1 Top-Down and Bottom-Up approaches illustration

2.3.1.1 Macro Economic Factors Analysis

Economic growth, political stability, condition of law practice is

closely related to investment environment. Through the information and analysis

regarding macroeconomic condition, investors could capture the big picture regarding

investment prospects of one country. Macroeconomic condition also helps investors

to recognize the risk involving certain country and be able to develop strategy to

minimize the risk.

Certain economic factors typically will affect all the companies

involves in it, thus robust undertanding the economic indices which reflect the

economy as a whole is significantly important. The utlization of indices as a base to

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forecast assumption is commonly used by analyst. There’s several economic indices

which proven useful in order to indicate the overall economic condition such as:

a. Gross Domestic Production (GDP)

GDP measure the total value of goods and services produced on certain country

on a certain period. The difference between GDP and Gross National Product

(GNP) is that GDP only estimate the total production of one country without

magnifying whether to productivity is sourced from inside the country or the

other way. Thus, GDP could proxy the measurement of productivity of one

country or even one industry. There’s two type of GDP which are nominal GDP

and real GDP. Nominal GDP disregard the effect price changes or inflation. Real

GDP involves the effect of price changes. Economic growth also commonly

measured by the growth of GDP. Generally government of one country always

publish the latest number of GDP, as GDP indicates the economic condition it

also shapes the perspective of the market regarding certain country. A positive

signal indicated by the GDP will send the signal of optimism to the market,

shaping the perspective which the economy is in sound condition but in reverse,

negative GDP result will raise concern regarding the economic condition.

b. Interest Rates

Bodie, et Al, (2009) stated that increasing interest rate will reduce the present

value of future cash flows, causing lack of attraction to investment. Investment

could shift rapidly in regard of change in interest rates. Central Bank or in

Indonesia named Bank Indonesia (BI) through monetary policy in charge of

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determining the basic interest rates, in Indonesia its called “BI Rate”. The shift in

BI rate affect time deposit rate and bank credit rate. In expansionary state BI

often decrease the interest rate in order to enhance the pace of the economy. In

reverse, in order to tame the overly circulated money BI often response with

decreasing the interest rate, which usually aimed to slow down inflation.

c. Inflation

Inflation is a process of increasing price of goods and services in general. High

inflation rate often associated with overheated economies where the demand of

goods and services is much greater than the production capacity which leads to

pressure to increase in price. (Bodie, et Al, 2009). In general inflation could lead

to decrease in investment. Because untamed inflation could leads to increase in

interest rates, decrease in buying power, and if the government unable to

intervere it could lead to recession.

d. Exchange Rate

Foreign exchange rate explains how much certain currency could be obtain with

other other currency. Multinational company highly exposed to exchange rate

due to the intensity of cross nation trade involved. United States Dollar (USD)

commonly considered as a benchmark to opposing currency. The effect of

currency to one company depends on the position of the company itself, whether

the company took position as net exporter or importer. Exchange rate affected by

various and complex factors, including productivity, inflation, unemployment,

interest rate and many other aspects.

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e. Oil Price

Oil price generally represent energy price, rising in oil price often causes global

concern and also one of the critical source of inflation. Oil price implies to many

aspects in economy, it becomes the reason behind the importance for oil price

indices.

f. Coal Price

Coal price obviously one of the major concern of coal mining industry. Global

coal price is one of the benchmark related to sales price. Lower coal price will

lead to lower overall selling price or in general term named average selling price

(ASP). In indonesia the benchmark for thermal coal price obtained by equally

weighted (25% each) four essential coal price index which are Indonesia Coal

Index (ICI), Platts 59 Index, New Castle Export Index (NEX), New Castle

Global Coal Index (GC)

2.3.1.2 Industry and Competitive Analysis

“Industry analysis is important for the same reason that

macroeconomic analysis is. Just as it is difficult for an industry to perform well when

the macroeconomy is ailing, it is unusual for af irm in a trobled industry to perform

well” (Bodie, et Al, 2009). Industry analyis is one of the important element in

conducting comprehensive fundamental analysis. It is important for the research to

understand the nature of the industry which company dwell in it. Bodie et. Al, (2009)

stated some of important element in industry analysis such as

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2.3.1.2.1 Industry Life Cycles

An industry has grow in cylical manner from very rapid start up

growth to stable mature growth. Generally industry life cycles is classified by four

stages:

a. Start-up Stage

Start-up stage is often characterized by significant rapid growth, for example in

technology industry such as personal computer in 1980s, or cell phones in 1990s

(Bodie, et Al 2009). The symptomps is significant increase in sales and earnings.

b. Consolidation Stage

Prior to start-up stage is consolidation stage, the survivors of start-up stage are

more becoming more stable. The industry growth is still faster than the overall

economy as products penetrate and become commonly used.

c. Maturity Stage

Maturity stage characterized by growth that is no faster than the overall economy,

product become more standardized and producer are competing on price basis

resulting in thinner profit margin.

d. Relative Decline

In relative decline stage, the industry might have slower growth than the overall

economy, or actually shrinks in negative growth for example the displacement of

floppy-disk to cd.
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2.3.1.2.2 Industry Structure and Performance

Porter (1985) emphasize on five determinant of competition: threat

of entry from competitors, rivalry between existing competitors, pressure from

substitute products, bargaining power of buyers, and bargaining power of suppliers,

these five factors is well known as porter’s five force.

a. Threat of Entry

Threat of new entry always become on key concern for existing players, the threat

of new comers could put pressure on price and earnings. Excess ammount of

producer could lead to oversupply and decreasing in prices. The easier one

company enter an industry the more intense the competition in the industry.

Barrier of entry could be an obstacles for new entrants to enter the industry.

Barrier of entry often be a key determinants of industry profitability. It could be in

form of strong distribution system of existing company, hefty amount of initial

capital requirement, or a brand loyalty. Those determinants could lead to strong

barrier causing potential new entrants unable to enter the business.

b. Rivalry between Existing Competitors

Rivalry between existing company has one of the strongest effect because an

expansion of one company must be compensate at the expense of a rival’s market

share. Industry with homogeneous goods is usually has more intense rivalry

between the existing company. The intensity of rivalry between the company will

increase following the increasing number of competitors, intense competition will

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lead to lower profit margin as competitors seek to add more market share to their

tally.

c. Pressure from Substitute Products

Pressure from substitute products indicate that there’s a competition from firm in

related industry. For example in energy generator business oil could be substitute

with alternative energy such as gas. The availability of substitutes product limit the

price and leads to lower profit margin.

d. Bargaining Power of Buyers

Large proportion or concentrated buyer of an industry often leads to stronger

bargaining power. Larger buyer with strong bargaining power often demand lower

price. Small number of consumer, and unspecialized goods often leads to greater

bargaining power of buyers. For example auto producer could put pressure on

suppliers of autoparts, this could lead the decreasing profitability in auto parts

industry (Bodie et Al, 2009).

e. Bargaining Power of Suppliers

The bargain power of suppliers at its strongest in a monopolistic control over

product, the lesser the producer of certain product the less competitive the supplier

and it could simply charge higher price. The availability of substitute product

could reduce the bargaining power of suppliers.

Analyst must stay updated with the current issues, facts, and news

of the concerning industries in which the company involves because it could affect

the long-term profitability and prospects of the company.

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Porter also propose three general corporate strategies for achieving advaced

performance:

1. Cost leadership strategy is trying to be the lowest cost producer in the industry

while offering comparable products.

2. Differentiation strategy is to offer distinctive product that are valued by the

customer so that the company could charge higher price.

3. Focus strategy is to gain competitive advantage regarding either cost leadership or

differentiation

2.3.1.3Analysis of Financial Report

Financial report is one relevant sources to understand the

company’s implementation of strategic choices.. With wide variation of industry

nonfinancial measures is critical to depict the corporate prospects, for example in coal

mining industry the measurement of reserve coal to total resources coal could

indicates the future coal production capacity of the company. For established

company financial ratios analysis is essential, one easier way to grasp the company’s

profitability, financial strength, risk and overall condition of the company. Financial

ratios are also a useful assesments of financial statement and provide standardzed

measures of firm performance. Financial ratios is often used compare risk and return

of different firms, and also to evaluate the changes in performance over time. Reilly

et Al (2006) classify financial ratios into several categories which are consist of

operating efficiency ratios to represent the measurement of the efficiency of operating

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activity, operating profitability ratio to represent the capability of the company to

generate profit from its operating activity, short term liquidity risk represent the

capability of the firm to fulfill its short-term liability, long term solvency risk

represent the capability of the firm to accomplish its long term debt and its financial

structure risk. One other essential part of financial report analysis is to observe the

cash flow of the firm. The analysis of cash flow covers the concern regarding

dynamics of cash flow such as:

a. How strong the cash gain from the internal operation of the company, a positive

stream of cash flow indicates profitable business and good management of

working capital. Strong cash flow from operation is key element to sustainable

business.

b. The company is required to fulfill the obligation of paying interest rates, checking

the operating cash flow for the ability of the firm to complete the obligation. Cash

flows from financing activities indicates the money flow regarding the financing

of a company.

c. The amount of money invested for growth, if the company invested a lot of money

on their expansion plan its an indicator of company. This highlight the part of cash

flow from investing activities.

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2.3.1.4Consideration in Using Accounting Information

In regard of assessing company’s past performance analyst rely on

financial report of the company which involving accounting information and financial

disclosures. Accounting information and financial disclosures which could be found

easilly in terms of publicly traded company, however there is some concern in

regards of te accurace of the published report. “The information that companies

disclose can vary substantially with respect to the accuracy of the reported accounting

results as reflections of economic performance and the detail in which results are

disclosed (Pinto, et Al. 2010). Quality of earning analysis emphasize on evaluating

how accurate the report to reflects the true economic performance of the company.

Analyst will develop more comprehensive fathom regarding the company and could

lead to better forecast. In general, analyst gather insights from various resources in

regard of industry and competitive analysis with financial statement analysis to

conduct a forecast of company’s sales, earnings, and cash flows. Analyst consider

both qualitative and quantitative measures to conduct the valuation and some

qualitative factors are necessarily subjective.

2.3.2 Selecting the Appropriate Valuation Model

One well fitted valuation model is essential in terms of valuation,

there is plenty of consideration to choose which model fit to the company. One major
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consideration is the industry or business the company dwell in. There is several

different approaches to conduct a valuation. Damodaran (2002) propose three general

approach to conduct a valuation which are discounted cash flows, relative valuation

model, and contingent claim valuation.

2.3.2.1 Discounted Cash Flow (DCF) Valuation

DCF Valuation argues that the value of an asset could be estimated

by calculating the present value of expected future cash flow which tied to the asset.

In the perspective of common stock holder, dividends is one familiar type of cash

flow, which are distributed to the shareholders authorized by the corporation’s board

of directors. “Dividends represent cash flows at the shareholder level in the sense that

they are paid directly to shareholders.” (Pinto et Al 2010). The present value model

which adopt dividends as the future cash flows is called dividend discount models.

The other type of cash flow is free cash flow. The idea of free cash flow comes from

the principle of common stockholders have the claim on the balance of cash flow

earned by the company after fulfilling liabilities of bondholders, government taxes

and preferred stockholders whether to company decides to directly distribute the cash

flow as dividends or not.

Free cash flow model generally classified into two, free cash flow

to equity model consider cash flow prior to the payment of debtholder liabilities, free

cash flow to firm defines cash flow before those payment. Discounted cash flow is a
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common technique to value debt securities, in terms of equity valuation the challenge

is greater. There’s two critical issues in discounted cash flow valuation, the cash flow

and the discount rates. Debt securities has certain amount of future cash flow. In

contrast, equity valuation involves great uncertainty in terms of estimating the future

cash flow. The future stream of cash flow in terms of equity affected by the business,

financial, technological and plenty other factors, it also involves greater variation

than debt securities certain cash flow. Debt securities usually refer to market interest

rates and bond ratings, however equity aluation involves subjective assesment to

appropriate discount rates. Due to the great uncertainty the idea of sensitivity analysis

is introduced. Sensitivity analysis is a tool in applying discounted cash flow with a

range of intrinsic values based on certain variables.

2.3.2.2 Relative Valuation

Relative valuation argues that the intrinsic value of an asset could

be estimated by looking at the pricing of comparable asset related comparable

variables such as earning, book value, sales, and many more. The basic idea of

relative valuation is that similar assets would sell at similar prices, and relative

valuation typically applied by using price multiples or enterprise value multiples. One

of the most familiar price multiple is price-to-earning ratio (PE), which is the price of

certain stock divided by earnings per share. A stock with PE that is relatively lower

than the comparables is stated as relatively undervalued. One of conservative

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investing strategies which the application of relative valuation is to simply

overweighting relatively undervalued assets and underweighting to relatively

overvalued assets. Relative valuation also often involves a group of assets

comparison, clustered as industry group, rather than a single comparison.

2.3.2.3 Contingent Claim Valuation

Contingent claim valuation utilize option pricing model to estimate

the intrinsic value of an asset which argued to have similar characteristic to option

pricing. The value commonly calculated using the Black-Scholes formula or

Binominal model.

2.3.3 Converting Forecast to Valuation

At time when analyst is finished with the forecast and in process to

convert it to valuation it is not just a matter of putting the forecast result into the

chosen model. (Pinto et Al, 2010) suggest two critical point of converting forecast

into valuation, the important aspects are sensitivity analysis and situational

adjustment. Sensitivity analysis provide different types of assumption analyst made

which leads to alteration in result. Situational adjustments may be required for several

condition, One example to valuing private company or illiquid stocks. It is often

called illiquidity discounts, analyst have to cut-off the price of the securities due to
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lack of liquidity, and investors will need an extra return in order to compensate the

lacking of liquidity.

2.3.4 Applying the Valuation Conclusion

The application of valuation is typically depends on the initial goal

of the research. Practical way of communicating the result of the analysis and

valuation is through research report. (Pinto et Al, 2010) point out several things

which describe an effective research report as following:

a. Contains timely information.

b. Written in clear and incisive language.

c. Objectibve well researched, with key assumptions clearly identified.

d. Distinguishes clearly between facts and opinions.

e. Containts analysis, forecasts, valuation and recommendation that is internally

consistent.

f. Presents suffcient information that the reader can critique the valuation.

g. States the risk factors for an investment in the company.

h. Discloses any potential conflicts of interest faced by the analyst.

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2.4 Return Concepts

Return on an investment has been the benchmark of what investor

gain or loss regarding their investment. Investors utilize return as a standard of

evaluation of the return they expect to obtain compared to the risk they have to bear.

The role of analyst is to point out the correct rates which will be utilized to discount

the future cash flow. In terms of equity there is two source of return which are

dividend yield and capital appreciation. There is several type of return and its

attribute which are important to comprehend, those are:

a. Holding Period Return

Holding period return is the return which investors obtain from holding an assets over

certain period of time. The common terminology such as annual return indicates

the time range of one year holding period, so does it goes with monthly return,

weekly return, and daily return. To understand the concept of holding period is

important because obviously an investment is not comparable unless it has the

same holding period.

b. Realized and Expected Return

The difference between realized and expected return is the time perspective.

Realized return simply defined as the return which already obtained in the past for

a certain holding period, and price. In future perspective expected return express

the expectation of investor towards an investment. Professional invetors often

estimate the expected return using valuation model, however an expected return
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does not necessarily based on specific model or valuation, it could simply be

express by personal point of view of the future return towards an investment.

c. Required Return

“Required return is the minimum level of expected return that an investors

requires in order to invest in the asset over a specified time period, given the

asset’s riskiness.” (Pinto et Al, 2010). Required return represents the value of

being fairly compensated to bear certain amount of risk. There is several approach

to assess required return, the capital asset pricing model for example. The capital

asset pricing model explains that the required return of an assets is equal to risk

free rate of return plus the premium or discount related to market sensitivity. The

required return for equity and debt is expressed as cost of equity and cost of debt.

To raise fund the issuer will have to propose certain expected return to compensate

the risk. The difference between expected return and realized return is called

expected abnormal return or expected alpha.

d. Expected Return Estimates from Intrinsic Value Estimate

The outcome of a valuation often indicates that the market value of a certain assets

is mispriced. For example a stocks is considered as undervalued stocks by 10%.

Over the holding time period the mispricing may be corrected and the assets will

obtain full reflection of intrinsic value, the mispricing could become worse and the

assets become more undervalued, the stock price stays the same and remain 10%

undervalued, be partially corrected, or reversing and become overvalued. Expected

value estimates is closely related to the estimation of intrinsic value estimate. In

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common case intrinsic value estimation is the benchmark for investors expected

return just as the example.

e. Discount Rate

Discount rate is a term to any rate utilized as the discount factors in order to obtain

the present value of future cash flow. Required return with marketplace variables

is generally used instead of the personal required return, however investor

sometimes will make an adjustment in regard of the required return.

2.4.1Equity Risk Premium

Equity risk premium is the excess return the investor requires to

hold relatively risky assets compared to risk-free assets. It is the difference between

required return on equities and required return on risk free assets. Thus, required

return on equity equals to current expected risk free return plus equity risk premium.

There is two general approach to assess equity risk premium one is based on

historical average of equity market return minus government debt return and, and the

other is based on current estimation of data.

a. Historical Estimates

In state of reliable long-term data is available historical estimates has been a

familiar and popular choise of estimating the equity risk premium. (Pinto et

Al,2010) points out four essential factors to be considered:

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1. The equity index to represent equity market returns, the essential aspect of

choosing the right equity index is to choose the one which best represent the

average return an equity investor gained during certain period of time.

2. The time period for computing the estimate. Fama and French (1989)

empirically studies that the expected return is countercyclical in the United

States, the expected premium is higher during bad times but lower during good

times. Thus, dividing data into subperiod does not increase the accurace of

estimates, in contrast the extension of observation period does improve the

accurace.

3. The type of mean calculated. There is two general way in choosing the type of

mean being calculated, the geometric mean and the arithmatic mean. Arithmetic

mean return best represent the mean return in single period. The most common

model for estimating required return is CAPM or multifactor model which are

single period model.

4. The proxy for risk-free return. The selection of risk-free rates proxy could be

represented in two ways, the long-term government bond return or the short-

term government debt return.The practice tend to rely more on long-term

government bond rate in premium estimation for multiperiod valuation. In

contrast for short term context of valuation government short-term debt return

is better as a proxy.

b. Forward-Looking Estimates

Equity risk premium is often based on expectations of economic and financial

indices in the future and such estimation is called forward looking or ex ante
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estimates. Two commonly used approach two asses expected required return in

forward-looking fashion are Gordon Growth model and macroeconomic model

estimates.

2.4.2Required Return on Equity

There are three general alternatives to assess required return on

equity the capital asset pricing model (CAPM), multifactor model such as Fama-

French and other related models, Build up method, such as bond yield plus risk

premium method.

2.4.2.1 The Capital Asset Pricing Model

Bodie, Kane, Marcus (2009) explains that CAPM is a primary result

from modern finance theory which could accurately estimate the relationship within

risk and expected return of an asset. CAPM is widely used because of the acceptable

accuracy for essential application. CAPM is based on several assumption which

basically is the simplication from actual practice. The main principle of the model is

that investors would evaluate the risk of one assets in a manner where the

contributoin of systematic risk. CAPM suggested that required return on a stocks

equals to current expected risk-free return plus beta times equity risk premium. Risk

free rate is the return of riskless investment.

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2.4.2.2 Risk Free Rate

Risk free rate represents the return expected by investors from an

zero risk securities. However, in practice risk-free rates does not exist because even

the safest investment carry a insignificant minor amount of risk. Generally risk free

rates represented by government debt instrument as it considered as one of the safest

investment.

2.4.2.3 Beta

“Beta is relative measure of risk – the risk of an individual stock relative to the

market portfolio of all stocks” (Fabozzi et Al, 2002). Beta is defined as the

measurement of systematic risk from one securities which could not be elimiated

through diversification. Beta of market portfolio is equal to 1. Beta will equal to more

than 1 if the securities is relatively volatile, vice versa if the securities is less volatlie

thus the beta will be less than 1.

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Figure 2.2 Illustration Beta of Securities A (1.5), B (1.0), C (0.6)

Source: Jones 2002

2.4.2.4 Weighted Average Cost of Capital

Part of valuing of a company using discounted cash flow approach is by determining

the discount rates. Debtholder and stockholder both expecting compensation in terms

of return from their capital injection. The expected return of debtholder and

stockholder are the appropriate discount rate to be utilized in the valuation. In order

to estimate the cost of capital or the discount rate is by using the calculation of

weighted average cost of capital. Weighted average cost of capital (WACC) is one

firm’s cost of capital which each category of capital is proportionaly weighted.

Capital sources such as equity and debt are involved in WACC. Company’s capital

strucutre often differ over time, thus WACC of the firm will changed following the

change in financial structure. Analyst often use target weights instead of current

financial structure weight. Target weights use the target capital structure of the
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company which will tend to used by the company over time, target weights also could

be useful in cases which current weightes misrepresent the company’s current

financial structure.

2.5Free Cash Flow Valuation

Discounted cash flow (DCF) valuation asses the value of a security

based on the present value of its expected future cash flow. In terms of dividends the

DCF valuation model using dividend discount model as an approach. The dividends

are the cash flows which actually received by the stockholders, however there’s other

type of cash flows which in fact available for distribution which is free cash flow.

Free cash flow (FCF) approach in two ways, free cash flow to firm (FCFF)and free

cash flow to equity (FCFE) . Contrast with the published dividends, free cash flow

could be obtain utilizing the available financial information. According to Pinto et Al

(2010) analyst like to use free cash flow model when faced with following condition:

a. The company is not dividend paying

b. The company paid dividends, but the dividend does not represent the actual

capacity of the firm to pay dividends. This often happen to growing company with

high investment expenditures.

c. Free cash flow is in line with profitability within the company with fair forecast

period
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The advantage of utilizing FCFF and FCFE in a valuation is that

they could be used to value the firm or the equity directly. While other similar cash

flow such as cash flow from operation (CFO) ,net inccome, earnings before interest

and tax (EBIT), and earnings before interest taxes deprecation and amortization

(EBITDA). For example EBIT does not consider the cash flow for government in

terms of taxes, interest expense for debtholder, net income does not consider the

amount of sales on credit (receivables) and CFO does not consider the reinvestment

cash flow which intended for the procurement of long-term assets to maximize long

term performance of the firm. Using FCF model is rather complicated compared to

dividend discout model model, since it requires the intergration of cash flow from the

company’s operation, financing, and investing activities.

FCFF represent the net cash flow for all capital contributer of the

firm, while FCFE represent the cash flow for the equity holder of the firm, due to the

different definition the treatment for the two approach are different. FCFF use

WACC as discount factor, after the calcualation the value of the firm will be

subtracted by value of debt. In other case FCFE could be directly discounted by

required return of equity and no need other treatment to value the equity.

2.6Relative Valuation

Relative valuation compares the value of an asset to the market for

similar or comparable asset. In order to conduct relative valuation analyst have to

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identify comparable assets and obtain the market value of the concerning asset. Then

convert the market value into standardized values, since the absolute price is

incomparable, the process of standardizing creates price multiples. By comparing the

standardized value or multiple for asset being analyzed to the standardized value for

comparable assets which might affect the multiple, analyst could judge whether the

asset is under or over priced (Pinto et Al, 2010). There are several multiples which

commonly use in terms of conducting relative valuation, the multiples are as follows:

a. Price Earning (PE) Ratio

Earning is the main focus which trigger investment value, and perhaps the chief

focus of analyst attention. The price earning ratio is commonly used in capital

market practice. There’s two approach of PE ratio, the trailling PE and the leading

PE. Trailing PE is the current market price divided by recent four quarters

earnings per share (EPS). Leading PE is estimated using expected future earnings

as denominator.

b. Price to Book Value (PBV) Ratio

PBV is the comparison between market price of stock with the book value per

share coming from the balance sheet. Book value per share is an attempts to

represent the investment that common shareholders have made in the company on

per-share basis. Book value per share is often more stable than EPS, and could be

used as an alternative if the EPS is negative.

c. Enterprise Value (EV) to Eearning Before Interest Deprecation Amortization Ratio

(EBITDA)
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EV/EBITDA responds to the need of comparing companies with relatively

different financial structure. Because EBITDA is an pre interest earnings figure

differ from EPS which is post interest. By adding back amortization and

depreciation, EBITDA cover for differences in depreciation and amortization

across businesses. In practice EV/EBITDA is frequently used in valuation of

capital-intensive businesses.