Hema Krishnamurthy

 For determining the share price for raising

further capital
 For sale of the enterprise or sale of shares
 For mergers and acquisitions
 For strategic sale or purchase of a business
 For lending or for borrowing funds as debts
 Valuation is a perception of the value of the
firm at a given point in time based on
several factors; They include:
 Industry environment; socio-political

environment; Company specific

 Business potential
 Intangibles – IP, Patents, Technology, Brand
 Track record
 Management capabilities
 COST BASED METHOD
◦ NET ASSET VALUE or BOOK VALUE METHOD
◦ REPLACEMENT COST METHOD
◦ LIQUIDATION METHOD OR BREAK UP VALUE METHOD

 INCOME BASED METHOD

◦ EARNINGS CAPITALISATION or PROFITS EARNING CAPACITY
VALUE METHOD (PECV)
◦ DISCOUNTED CASH FLOW METHOD (DCF)

 TRANSACTION MULTIPLES OR RELATIVE MULTIPLES

 Net Asset Value Method
◦ Net Fixed Assets 2000
◦ Net Current Assets 1500
◦ Capital W.I.P 500
◦ Investments at cost 500
 Total Assets 4500
◦ Less :
◦ Revaluation reserve 1000
◦ Long term liab. 500
NET ASSET VALUE 3000
 Replacement Cost Method:
◦ Book values adjusted to reflect replacement cost at
current prices
 Inventories are valued at net realizable value
Operating F.A at current replacement cost less depn.
Non-operating F.A at fair market value

 Break-up Value or Liquidation value:

◦ Market value if sold on piecemeal basis

 Problem – Ignores profit earning potential and

value added over years of experience!
 Goodwill Valuation – Method-I (Super profits)
◦ ROCE = PBIT/ (NFA+NCA)
◦ Ascertain maintainability of profits
◦ Compare with industry std. and other companies
◦ Arrive at normal ROCE
◦ Normal ROCE applied to Company Capital employed
=Normal operating profit
◦ Actual profit – Normal op. profit = Super profit
◦ Goodwill = capitalized SP over valuation horizon-
no. of years
◦ Alternately – forecast SP and discount at a rate
 Goodwill – method II ( Normal capitalization)
◦ Normal Capital employed = Normal ROCE/
Act. ROCE x Actual Capital
◦ Goodwill = Actual capital-Normal capital

 Final valuation :
◦ Equity Valuation = Asset value + Goodwill –
Preference
capital
◦ Value per share = Total Equity value/No. of
outstanding eq. shares
 Earnings Capitalization – (PECV)
◦ Average future maintainable post tax profit = 2000
◦ Capitalization rate considered = 12%
◦ Capitalization factor = 100/12 = 8.33
◦ Capitalized value of earnings = 2000 x8.33 = 16660
◦ No. of o/s equity shares = 150
◦ Value per share = 16660/150 = 111.06
 Discounted Cash flow method :
◦ Most popularly adopted method as it captures the cash flow
impact of intangibles such as goodwill, brand equity, IP etc.,

 DCF determinants are :

◦ Free Cash flow –
◦ Cost of Equity and WACC (Weighted Average cost of capital)
◦ Terminal value of FCF
 FCF – Free Cash Flow :
◦ Net Operating Cash flow after tax (NOPLAT +
Depreciation and w/o s) +/-
◦ Financing Cash Flow +/-
◦ Investment Cash Flow
 NOPLAT ( Net Operating Profit Less Adjusted for Tax)
= EBIT – Tax on EBIT
 Financing Cash flow = Additional Equity and/or
borrowings
 Investment Cash flow = Capex + Incremental
Working capital
 SAMPLE FREE CASH FLOW STATEMENT
Year 1 Year 2 Year 3 Year 4 Year 5
EBIT 1,908 2,756 5,681 7,606 13,222
Less: I Tax 342 614 1,056 1,958 2,983
NOPLAT 1,566 2,142 4,625 5,648 10,240
Add : Depn. 304 362 455 510 543
& w/o
GROSS CASH 1,870 2,504 5,080 6,158 10,783
FLOW
W.cap. 640 690 1,061 1,548 2,130
Change
Capital exp. 385 1,000 1,400 525 1,025
Inter Co. Loan 2,500 0 0 (2,000) 0
GROSS 3,525 1,690 2,461 73 3,155
INVESTMENTS

FREE CASH (1,655) 814 2,619 6,084 7,628

 CAPM – Capital Asset Pricing Model – a widely used method

 E(Ri) = Rf + [E(Rm) – Rf] Beta of i

 Expected return on an investment depends on

 The Pure time value of money - as measured by the risk free
rate – Rf
 The reward for bearing systematic risk – as measured by the
Market risk premium –[E(Rm)-Rf]
The amount of systematic risk - as measured by Beta of the
asset, which shows the systematic risk present in an asset,
relative to the risk in an average asset
 Total Risk = Systematic Risk + Unsystematic
risk
 Systematic Risk = Market risk, influences a
large number of assets eg. Interest rates, GDP
growth etc.,
 Unsystematic Risk = Unique or Asset specific
influences a small number of assets
 Unsystematic risk can be eliminated by
diversification; therefore Expected Return on a
risky asset depends only on the asset’s
systematic risk.
 Amount Weight Pre- Tax Post Tax WACC
age Rate Rate (1-
Tax rate)

COST OF DEBT
LOAN 1 300 0.25 12% 8.4% 2.1%
LOAN 2 200 0.17 14% 9.8% 1.7%
COST OF EQUITY
PREFERENCE 200 0.17 10% 10% 1.7%
EQUITY 500 0.41 15% 15% 6.1%
TOTAL 1200 1.00 11.6%
* Tax rate assumed = 30%
TERMINAL VALUE OF FCF =

FCF OF LAST YEAR OF THE DISCRETE

PERIOD/ (WACC- EXPECTED GROWTH
RATE OF FCF)
 Step 1 – Forecast financials – PL, BS, CF

 Step 2 – Prepare FCF

 Step 3 – Compute WACC

 Step 4 – Arrive at Terminal Value

 Step 5 – Value business – Present value of FCF

discounted at WACC + PV of terminal vlue
 Useful when DCF is not suitable – where
company is small and is yet to establish a
pattern of cash flow; or if cash flow is uneven
 Some parameters that are used :

◦ Sales/Revenue/Gross revenue
◦ EBITDA
◦ PAT
◦ EPS
◦ NAV
◦ P/E of comparable companies