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Beauty lies in the eyes of the beholder; valuation in those of the buyer

Valuation
Valuation is worth of an asset which can be an equity, bond, a firm etc. To realize benefit of an investment such as return, valuation is must. Business valuation is a process and a set of procedures used to estimate the economic value of an owners interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business Input for valuation varies according to type of asset Business is based on expectations which are dynamic, valuation also tends to be dynamic and not static which means that the same transaction would be valued by the same players at different values at two different times.
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Why Valuation?
CEO/CFO/Operating Mgr Insiders Decision Making Identifying Opportunities

FIIs / MFs / Insurance Comp Investors Pension/Hedge Funds Retail Investors

Investment Bankers Consultants Sell side / Buy Side Analyst Credit Analyst

Key Valuation Questions


What is the company worth? Public and private market valuations Intrinsic Value What can/will someone pay? Who is the seller? Public or private Insider ownership or sizable public float Who are the potential buyers? Strategic or financial What is the context of the transaction? Privately negotiated sale or auction Hostile or friendly Economic conditions Sensex / Nifty Economic Outlook

Approaches to valuation
Valuation is based on going concern approach. Determination correct valuation is essential for successful investment . Valuation may change according to type of the firm manufacturer / service provider. Tools available for valuation
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Key Valuation tools


Discounted Cash Flow
Present value of projected unlevered free cash flow Captures the intrinsic value of the business

Relative Valuation

Based on market trading multiples of comparable comp Usually focuses on forward looking Profit / EBITDA / Cash Flow

M&A Comparables

Based on multiple paid for comparable comp. assets in sale transaction Focus mainly on multiples of Historical Profit / EBITDA / Cash Flow

Asset Valuation

Based on fair value of individual assets Book Value may not be equal to fair value

Sum of Parts

Divides the business into separate sub-entities (parts) Add the value of each part to find the total value

Book Value

Principles of Valuation

Depreciated value of assets minus outstanding liabilities

Liquidation Value
Amount that would be raised if all assets were sold independently

Market Value (P)


Value according to market price of outstanding stock

Intrinsic Value (V)


NPV of future cash flows (discounted at investors required rate of return)
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Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial premiumon the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy. a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy. it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense.
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Synergy

Enterprise Value
Market Cap + Total Debt Total Cash & Short Term Investments EV is a measure of theoretical takeover price, and is useful in comparisons against income statement line items above the interest expense/income lines such as revenue and EBITDA. Commonly adopted valuation model = EV/EBITDA
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Cost of acquisitions
Payment to equity share holders (No. of equity shares x MP of equity share) + payment of preference hare holders + Payment to debenture holders + payment of other external liabilities ( creditors etc) + Obligations assumed to be paid in future (pension etc) + Dissolution expenses + Unrecorded / contingent liabilities (LC/BG) - Cash proceeds from sale of assets of target firm.
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Approaches to valuation

Income approach

Market approach

Asset approach.

Capitalization method DCF method

Comparable company method

Adjusted Book Value method

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Approach to valuations - DCF


Income approach Depends on appropriate discount rate and definition of cash flow. It involves projected cash flow over the forecasted period and terminal value to be discounted to arrive at present value.

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DCF model steps involved


Estimate the free cash flow for the forecast period. Decide the growth in earnings Compute the cost of capital (WACC) to decide the discounting factor. Compute the continuing value or terminal value Determine the value of the firm. In case of unlevered firm, then the entire value is the value of equity. In case of levered firm (financed by debt & equity), value of the debt to deducted from the value of the firm to decide the value of equity. Then decide the value of equity. Value can be Present value + continuing orTerminal value 14

Overview of Discounted Cash Flow

Enterprise Value is sum of


Present value of all its expected cash flows for a period (year 2008 till 2016) Present value of terminal value calculated for future point in time (year 2016)
500 Cash Flo ws (Rs mn) 400 425

300 200 89 1 00 1 7 0 2008 2009 201 0 201 1 201 2 201 3 201 4 201 5 201 6 24 24 31 53 1 02 10 1

Terminal Value

A nnual cashflo w

Terminal Value

DCF is a rigorous method (compared to Relative Valuations) 15

DCF valuation basis for approach

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

CFt V t 1 t 1 r

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Equity versus Firm valuation


Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm It involves two approaches Cash flow to equity model Cash flow to firm model
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Equity valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. Value of Equity =

CFt V t 1 t 1 ke
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Firm valuation
The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital

CFtoFirm V t 1 t 1 WACC
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Firm value Vs Equity valuation


To get from firm value to equity value, which of the following would you need to do? Subtract out the value of long term debt Subtract out the value of all debt Subtract the value of all non-equity claims in the firm, that are included in the cost of capital calculation Subtract out the value of all non-equity claims in the firm Doing so, will give you a value for the equity which is greater than the value you would have got in an equity valuation lesser than the value you would have got in an equity valuation equal to the value you would have got in an equity valuation
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Cash flow & discount rates


Year CF to Equity In $ 50 60 68 76.20 83.49 1603.0 Interest expense in $ 40 40 40 40 40 CF to firm 1 2 3 4 5 6 Terminal value 90 100 108 116.20 123.49 2363.008

Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) The current market value of equity is $1,073 and the value of debt outstanding is $800. Source Aswadh Damodaran 21

Cash flow & discount rates


Method 1: Discount CF to Equity at Cost of Equity to get value of equity Cost of Equity = 13.625% PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 + (83.49+1603)/1.136255 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = $1873 PV of Equity = Market Value of - Debt PV of Firm = $ 1873 - $ 800 = $1073
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Approach to valuation market approach It is used when valuing a private firm. Value under market approach is determined based on prices that have been for similar assets in the market . How an exactly similar firm ( in terms of risk, sales, growth and cash flow ) is priced. It is more realistic since it measures relative market value rather than intrinsic value.

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Value of firm comparable firm approach


Comparable" valuation methods are a set of methods that use comparable situations to infer the value of a firm. The comparable company method of valuation is one such technique. Comparable valuation methods estimate a firm's value by multiplying a ratio estimated from comparable firms (valuation multiple) times the firm's earnings before interest, taxes, depreciation, and amortization (EBITDA), earnings before interest and taxes (EBIT), revenue, or some other performance measure. EBITDA has emerged as the most commonly accepted performance measure on which to base valuation multiples.
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Value of firm comparable firm approach The comparable company method uses valuation multiples that are derived from observed stock market prices of comparable publicly traded firms When the target firm's stock is not publicly traded, an estimate of its market price can be constructed using the market prices of comparable firms in the same industry Estimates are usually based on performance measures such as the priceto-cash-flow-per-share ratio or price-tobook-value ratio, Beta factor etc

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Value of firm comparable firm approach


The concept behind relative valuation is simple and easy to understand: the value of a company is determined in relation to how similar companies are priced in the market. Here is how to do a relative valuation on a publicly listed company: Create a list of comparable companies, often industry peers and obtain their market values. Convert these market values into comparable trading multiples, such as P/E, price-to-book, enterprisevalue-to-sales and EV/EBITDA multiples. Compare the company's multiples with those of its peers to assess whether the firm is over or undervalued.
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Value of firm comparable firm approach


A word of caution Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business is teetering on the verge of collapse? 27

Value of firm comparable firm approach


In 1998, when Kmart's share price was downtrodden, it became a favorite of some investors They couldn't help but think how downright cheap the shares of the retail giant looked against those of highervalued peers Walmart and Target. Those Kmart investors failed to see that the business's model was fundamentally flawed. The company's earnings continued to fall and, overburdened with debt, Kmart filed for bankruptcy in 2002. Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or, like Kmart, the company might have intrinsic 28 shortcomings that justify a lower multiple.

Value of firm comparable firm approach ABC company has sales RE 200 crore ,MV/EBDITA@ 14 & MV/FCF@ 10. An investor wants to acquire this company based some variables EV/Sales, MV/EBDITA & MV/FCF, PAT, etc He wants to give 50% weight age to earnings in the valuation process. He has identified 3 comparable firms.
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Value of firm comparable firm approach


Company A Company B Company C

EV/Sales

1.4

1.1 15.0

1.1 19.0

MV/EBDITA 17.0

MV/FCF

20

26

26

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Value of firm comparable firm approach


Valuation multiples of comparabl e firms A
EV /sales

average

1.4
17.0 20

1.1
15.0 26

1.1
19.0 26

1.2
17.0 24.0
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MV/EBDITA

MV/FCF

Value of firm comparable firm approach


Value of ABC based on comparable multiples Weightage to P/S,P/E,P/BV 1,2&1.
ABC co Average value

sales MV/EBDITA MV/FCF

200 14 10

1.2 17.0 24.0

240 238 240

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Value of firm comparable firm approach Weighted average will be { 240x1) + (238 x2) + (240x1)}/4 = Re 318 cr Value of ABC = Re 239 cr.

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Approach to Valuations- Asset approach It involves two measurements viz Adjusted Book value and Liquidation method. Adjusted Book value method assumption based on going concern method and accordingly assets are valued . Liquidation method assumption is based on business will cease and liquidation will occur. Realizable value cost of realization.

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Free cash flow to firm


Free cash flow (FCF) is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on.
Free cash flow = EBIT(1-t)+depreciation - (capital expenditure + changes in WC). Discount rate cost of capital. Free cash flow approach is based on growth in operating income rather than net income. Free Cash Flow measurement deducts increases in net working capital. Present value of CF provides an estimate of the value of the firm. When a company has negative sales growth it's likely to diminish its capital spending dramatically. Receivables, provided they are being timely collected, will also ratchet down. All this "deceleration" will show up as additions to Free Cash Flow. However, over the longer term, decelerating sales trends will eventually catch up.
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Free Cash flow to equity model


Free cash flow to the firm it means cash flow available to equity and outside claims. Value of the firm is arrived at by discounting cash flows after deducting operating expenses, reinvestment needs and taxes but before payment to any debt and equity holders. Discounting rate @ WACC. Free cash flow to equity how much cash left after meeting all outside claims = PAT + Depreciation +Amortization ( Capital expenditure + incremental WC)

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Cash flow to Firm model


EBIT Expected to grow at 5 % for 5 years Capital expenditure Assume increase 5% p.a Depreciation Revenue Expected to grow at 5 % for 5 years Re 500 lacs.

Re 300 Lacs Re 200 lacs Re 7000 lacs

WC as % of revenue
Tax rate Capital expenditure are off set by depreciation

25%
36%
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Free cash flow to the firm = EBIT(1-t)+depreciation and amortization capital expenditure change in working capital

0 EBIT - taxes - capex Change in WC FCFF 500 180 100

1 525 189 105 90

2 550 198 110 90

3 580 210 115 95

4 610 220 120 105

5 640 230 126 100

220

141

152

160

165

38 184

Estimation of change in working capital

Revenues 7000

7350 7720

8100

8510

8930

Working capital

1750

1840 1930

2025

2130

2230

Change in WC

90

90

95

105

100

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Estimating free cash flow to equity


XYZ co requires Re 12 lacs for a project. Debt portion Re 4 lacs @ 8% Interest is paid for 5 years and entire principal with interest is repaid at the end of 6th year. Tax rate @ 36%. Interest payment is subject to tax benefit. Expected cash flow Re 80,000 p.a. Cash flows are expected to grow @ 30% for the first 4 years and 75% from 5th year. Estimate free cash flow to equity. FCFE = (net operating income-interest)+ Depreciation and amortization capital expenditure change in working capital principal repayment + proceeds from new debt issues.
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Yr

FCFF

Debt

Int.(1-t)

Principal FCFE repaid

1 2 3 4 5 6

(12,00,000) 4,00,000 Equity 8 + debt 4) 80,000 20,480 1,04,000 20480 1,35,200 20,480 1,75,760 20,480 3,07,580 20,480 5,38,265 20,480

(8,00,000)

59520 83520 1,14,720 1,55,280 2,87,100 4,00,000 1,17,785


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Role of cost of capital


Cost of the capital (discount rate) is used to convert expected future free cash flows into present value for all investors. WACC to be used to cover all contributors of capital. It should be after tax (marginal tax rate). Return for investor should be based on nominal return after factoring inflation and risk.
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Where Does the Discount Rate (k) Come From?


CAPM: k = rf + bxRP Beta (b) is estimated using historical data and is available from many sources The risk free rate (rf) is the current Treasury rate
Typically the 3-mo rate, but other are sometimes used

The risk premium (RP) is a historical average relative to the rf used


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Cost of capital
WACC kd(1-t)BV+kp P/V+ Ke S/V Ke = cost of equity Kd = cost of debt T = marginal tax rate B = Market value of interest bearing debt V =market value of enterprise being valued ( V=B+P+S) P = Market value of preference shares S = Market value of equity
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Weighted average cost of capital Proportion of Equity @50 ,Preference @10 & Debt 40%. Cost Equity @ 16, Preference @ 12 & Debt @ 8% WACC = (0.5)(16)+(0.10)(12)+(0.4) (80) = 12.4% WACC =kd(1-T)B/V+kpP/V+KeS/V

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Cost of equity
Cost of equity is the expected return by investors. There 2 methods CAPM Arbitrage Pricing Model.

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Capital Asset Pricing model


In 1952,Harry Markowitz, showed exactly how an investor can reduce standard deviation of portfolio returns by choosing stock that do not move exactly together. This theory explains the relationship between risk and return. In mid 1960s, three economist William Sharpe, John Lintner & Jack Treynor have propounded the theory of CAPM and answered the basic questions posed by Markowitz.
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CAPM
Securities are risky since returns are variable SD measures the variance Risk of security arises from market and unique risk Portfolio diversification can eliminate unique but not market risk Contribution of a security to the portfolio risk is measured by beta
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CAPM
Assumptions All investors aim to maximize their returns All operate on common single period planning horizon All are rational and always look at risk and return All investors are price takers, i.e. no investor can influence market price by his scale of operations Dividends and capital gains are taxed at the same rate. All securities are highly divisible i.e. can be traded in small parcels
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CAPM
CAPM is an equilibrium model which describes the pricing of assets, as well as derivatives. Expected return of an asset equals the risk less return + risk premium. Expected security return= Risk less return + beta x (expected risk premium) In short, CAPM describes relationship between risk and expected return and that is used in the pricing of risky securities. Beta is used to measure additional risk (systematic) faced by the investor.
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Systemic risk and un systemic factor in portfolio of investments. investors expectations - Higher the risk higher the return. Beta factor - each has company has a beta factor. A companys beta factor is that companys risk compared to the risk of over all market. If a company has a beta factor of 3.0 , it is said to be 3 times more risky than the over all market. Investor investing in such company , expectation of return will be higher. Market risk premium or the price of taking risk is the difference between the expected rate of return in the market and risk free rate. Market risk premium is based on the past or future.
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CAPM

CAPM Market risk premium


Market risk premium is based on the past or future. What decides the size of the premium? 1.variance in the economy higher the volatility (uncertainty) vis-avis future growth, higher is the risk premium. What is your on India, US, China ?. 2.political risk higher the political instability ,higher the risk premium. Developed versus emerging market. Russia versus India Structure of the market large, diversified and stable companies, risk premium is low. China versus India.
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Market risk premium- Historical Period Approach. Simple of estimating premium based on difference between actual returns on stock over along period and return on risk free asset. Problems 1. length of the period 2. choice of risk free security T-Bill/G-Sec. 3. arithmetic and geometric averages.- each one has its own pros and cons. Arithmetic measures average of the annual returns for the chosen period and geometric measures compounded values. But market risk premium lies in between 53 two.

Determination of Beta.
Beta is influenced by 3 factors 1.type of business- expected to be in cyclical industry such as steel, real estate etc. 2.degree of OL (contribution/EBIT) Indicates fixed operating cost. Lower the better. 3.degree of FL ( EBIT/EBT) indicates fixed financial cost . Lower the better. What is FL of Infosys ? Economic conditions Inflation/Deflation. FMCG verus Pharma. Increase in OL/FL shall increase the Beta of the company.
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Security market line

>1
B A B A

B
C

<1

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Security market line


Rate of return 17.5 B 15.0 A 12.5

Rf=10

05

1.0 Beta

1.5

2.0
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Capital Asset Pricing Model (CAPM)


Ks = Krf + (Km Krf) Ks required rate of return Krf = Risk free rate (rate of return on risk free investment. E.g. GOVT.securities = beta Km expected return on the over all stock market
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CAPM
Model that links the notions of risk and return Normally government securities are taken as risk free scurrilities and its rate as risk free rate. Historical premium earned by a equity market index over and above risk free rate is used to estimate the expected return on the market. Cost of equity thus obtained is used as discount rate for cash flows. Helps investors define the required return on an investment As beta increases, the required return for a given investment increases
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Capital Asset Pricing Model (CAPM)


E.g. Risk free rate @ 5%.Stokck market rate of return @ 12.5 % next year. Beta factor of XYZ company @ 1.7. Expected rate of return ? Ks =Krf + ( Km Krf) Ks = 5% +1.7(12.5% - 5%) Ks = 5% +1.7(7.5%) Ks = 5% + 12.75% Ks = 17.5% Decision if XYZ is not giving 17.5%, investor will think of investing in other share.

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CAPM Empirical Evidence


It is difficult to measure expected return since actual return may or may not match with expected return. It relies more on historical data. To test the model , portfolio should comprise all risky investments including stocks, bonds, real estate etc. Most market indexes contain only common stocks. It assumes that that beta is the only reason that expected returns differ. But average return on smaller stocks has been substantially larger than predicted by CAPM. It assumes T. Bills are risk free. But it does not take in to account the real return after factoring inflation.
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Beta versus risk premium XYZ co is a private operating in textile industry. D/E- 0.2.Tax rate @ 36%. Estimate the Beta if D/E goes up to 0.23. Information on other firms in textile industry Firm A B Beta 1.10 1.22 D/E 0.24 0.33

C
d

1.35
1.20

0.22
0.20
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Beta versus risk premium


L = U [ 1+ (1-t) (D/E) ] L = levered beta for the equity firm. U = unlevered beta of the firm t = corporate tax rate D/E = debt/equity ratio Average of comparable firm 1.22(1.10+1.22+1.35+1.20 /4) Unlevered beta for comparable firms 1.22 /[ 1+(1-0.36) (0.25)] = 1.22/1.16= 1.05 for XYZ Co = 1.05 [1+(1 -0.36) (0.23)] = 1.05 x 1.15 = 1.21 approximately.
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Arbitrage Pricing Model (APM) CAPM measures only one variable i.e. risk free and market return. APM measures security return with other variables such as Industrial production index to show strength of the economy Short and long term interest rate vis--vis inflation rtc Empirical studies suggest that that APM explains expected returns better than single factor CAPM. Default risk between yield to maturity on aa & bb rated long term bonds APM cost of equity can be measured by Ke = Rf + [ E(F1) Rf ] 1 +[E(F2) Rf ] + +[E (Fk) - Rf] k E(F1) = Expected rate of return on a portfolio that resembles the kth factor independent of all other factors. k = sensitivity of the stock return to the kth factor.
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Arbitrage Pricing Model (APM) T- bill trades @ 4.5%. Assume 3 different factors are considered. Estimate the cost of equity
Factor 1 Factor 2 Factor 3

Risk 4% premium

4.5%

3%

Beta

1.25

0.95

1.15

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Arbitrage Pricing Model (APM)

Cost of equity = 4.5% + (1.25 x4%) + (0.95 x 4.5%) + (1.5 x 3%) = 4.5 + 5 + 4.275 + 3.45 = 17.225%

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Terminal value or continuing value A companys can be separated in to 2 periods i.e. cash flow (PV) during explicit forecast period and after explicit forecast period (terminal value) . Value = PV during Explicit period+ PV after explicit forecast period. Value of the firm = V CF + terminal value 1 k -----------------( 1 + kc )^n
n t t 1 t

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Terminal value or continuing value


There 3 ways to compute the terminal value 1.Liquidation value method assumes firm cease to operate in future and sell is assets. First method to measure LVM book value of the firm adjusted for inflation during that period. Second method - value of the asset is determined based on the earning power of the asset. Estimate PV of cash flows. 2.Multiple approach measured by way Book value to sales or PE ratio. 3.stable growth model assumes growth in cash flow at constant rate forever . This model is based on size of the firm , existing growth and magnitude and sustainability of competitive advantages.
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Terminal value or continuing value


A ltd wants to buy B ltd who is in bio tech business for developing products for selling to big pharma companies. Development cost to result a cash out flow of Re 10 lac duirng the first year. Licensing fee result inflow of Re 5,10,15 & 20 lac during next 5 years. Expected growth in cash flow @ 5% after 5th year. Expected discount rate@15%.and then drop to 8% after 5th year. Calculate the value of the firm.
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Year 1 2 3 4 5 NPV

Cash flow (10) 5 10 15 20

Disc.@ 15% 1.15 1.323 1.521 1.749 2.011

Present value (8.69) 3.779 6.575 8.576 9.945 28.875


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Terminal value or continuing value


Total sum of PV - 28.875 -8.690 = 20.185 Terminal valuet = cash flow t+1 ------------------r -gstable cash flow t+1 = cash flowt (1+g) = 20(1+0.05 ) = 21 lac Terminal value = 21(0.08 0.05 ) = Re 700 lac PV of terminal value = 700/2.011 = 348.08 Value of the firm = 20.185 + 348.08 = Re 368.265 lac.
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Two stage dividend discount model


It assumes 2 stages of growth. Initial phase is extra ordinary growth phase growth is expected to be greater than economy . Larger the size, shorter the growth rate. Estimation is based on current earnings second stage is stable growth for a long time. Valuation to factor in both the stages. Required rate of return CAPM or APM Types of growth 1.Constant growth rate during the high growth period earnings are constant for the high growth period after which drops to stable level
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Two stage dividend discount model


2. Constant growth initially followed by gradual reduction to stable growth high growth dose not drop suddenly but gradually slips to stable growth. Growth and pay out ratio are different in every period of the high growth period. Pay out ratio (DPS/EPS) reflect expected growth in earnings. Payout ratio can be calculated from fundamental growth model g = b { ROA + D/E [ ROA i(1 t)] } b = retention ratio = 1 pay out ratio Pay out ratio = 1-b = 1 { g/ROA+D/E [ ROA i (1 t)] ROA = return on assets = EBIT (1-t) (BV of Debt + BV of equity ) D/E = debt equity I = interest on debt t = marginal tax rate
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Two stage dividend discount model


Vo =
DPS t V 1 ke, h t t 1
n
n

+ Vn / (1 + Ke,s)^ n

Ct Vn t 1 t 1 R

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Value of equity in 2 stage discount model XYZ ltd is a manufacturer of electronic goods. Reported EPS in March,2005 Re 5.7 and dividend @ Re 2.28. Tax rate@ 40%.T.bill rate@ 7%.Market premium 5% Estimate value of equity using dividend discount model Particulars High growth period 4 years ? 1.3 15% Stable growth

Length of the period Exp. Growth. rate. Beta Ret. on. assets

Perpetual after 4 yrs 8% 1.15 15%

D/E
DPS

1
40%

1
?
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Int. on. debt

8%

8%

Value of equity in 2 stage discount model


Expected growth rate during high growth period (g) b { ROA + D/E [ ROA i(1 t)] } 0.6[0.15 +1 { 0.15 0.08(1-0.4}] 0.1512 or 15.12% Pay out ratio for the stable growth period

= 1 { g/ROA+D/E [ ROA i(1 t)] = 1 { 0.08/0.15 +1[0.15 0.08 (1-0.4) = 1 0.317 = 0.683 or 68.3% Estimation of equity follows
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Value of equity in 2 stage discount model- Estimation of value of equity

Year 1

EPS 2

DPS 3

Disc.rate@13.5% 4

PV 5(3/4)

1
2 3 4

6.56
7.55 8.69 10.00

2.6424
3.070 3.477 4.003

1.135
1.288 1.462 1.659

2.311
2.344 2.378 2.411

Ks = Krf + (Km Krf) High growth rate = 7%+1.3(5%) = 13.5% Stable growth rate = 7% +1.15(5%) = 12.75%

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Value of equity in 2 stage discount model Total PV of dividends =Re 9.45 Terminal price = expected dividend per share n+1/(r gn) Expected EPS = 10(1+0.08) = 10.8 Expected DPS = 10.8 x 0.683 = 7.37 Terminal price = 7.37/(0.1275 0.08) =Re 155.15 PV of terminal price 155.15/1.659=93.52 Value of firms equity = 9.45+93.52 = Re 102.97.
77

Value of the firm


XYZ lit company is in the buisness of house hold products EBIT (depreciation Re 350 lacs). in 2004 is Re 1200 lac. Capex in 2004 = Re 420 lac and working capital 10% of revenue (Re 13,000 lac) Interest on debt (pretax ) - 8% Tax rate 40% T-bill 7% = 1.10 D/E = 50% Expected revenues , earnings, capital expenditure & depreciation to grow @ 9.5% p.a from 200-09 after which growth is expected by 4%.( (capital spending will offset depreciation in the steady state period) Company plans to reduce D/E to 25% and pretax interest drop to 7.5%. Annual market premium is 6% Estimate the value of the firm
78

Value of the firm


Base year information in 2004. EBIT Re 1200 lac Capex Re 420 lac Depreciation Re 350 lac Revenues Re 13000 lac WC as % of revenue 10% Tax rate 40% High Growth phase Period 5 years Expected growth in FCFF 9.5% Beta -1.10 Cost of debt 8% D/E 50% Stable growth rate Expected growth in FCFF - 4% Cost of debt 7.5% D/E 25%
79

FCFF for next 5 years

2005 EBIT
- Tax@40% - (Capex)
1314 525.6 76.65

2006 2007
1438.83 575.53 83.93 135.23 1575.52 630.21 91.91 148.08

2008
1725.19 690.07 100.64 162.15

2009
1889.09 755.64 110.20 177.55

Termin al value
1964.65 785.86 114.61 81.86

-(Ch. in .WC) 123.5

FCFF

588.25

644.14
540.16

705.32
541.64

772.33
543.13

845.7
544.21

982.32

538.69 PV of FCFF@9.2%

80

Estimation of change in WC

REVENUES

13000

14235

15587.33

17068.12

18689.59

20465.10

21283.70

WC

1300

1423.5

1558.73

1706.81

1868.96

2046.51

2128.37

Ch. in. WC

123.5

135.23

148.08

162.15

177.55

81.86

81

Value of the firm


Cost of equity for high growth rate = 7%(T-bill) + 1.1(6) = 13.6% Cost of capital during high growth rate =13.6 x 0.5 + 8 ( 1-0.4) x 0.5 = 6.8 + 2.4 = 9.2% Estimation of Beta during stable growth phase Since expected DE to be reduced and the company becomes less risky. Hence Beta is expected to be reduced.. New Beta can be New Beta = old beta/ [(1+(1-t)old DE ] x [1+(1-t)new DE ] = { 1.1/{1 + (1- 0.4) 0.5) } x {1+ ( 1- 0.4) 0.25 } = 0.846 x 1.15 = 0.97 Cost of equity for stable growth phase = 7% + 0.97(6) = 12.82% Cost of capital during stable growth phase = 12.82 x 0.75 + 7.5 ( 1-0.4) x 0.25 = 9.615 + 1.125 = 10.74

82

Value of the firm


Terminal value = 982.32 / ( 0.1074 0.04) = 14,639.64 PV of TV = 14,639 .64 /(1.092)^5 = 9421.8 Value of the firm = 2707.83 + 9421.8 = 12,19.63.

83

Adjusted Present Value method (APV)


APV is the variant of DCF approach used to value the firm. It is very appropriate for valuing companies with changing capital structures and it is different from acquiring firm. APV approach values FCFF with of target firm in 2 components i.e. one is entirely equity financed and impact of debt ( of acquired company ) on valuation in terms of tax benefit and bankruptcy cost. E.g. TATA CORUS is a LBO. D/E of Corus is expected to go up, it has to be valued taking in to account tax shied available due to debt.
84

APV method
Liabilities (Re in lac) Equity ( 4 lac shares of Re 100 each Reserves Amount Assets amount

Hypothetical ltd ( H) wants to acquire Target ltd (T). Balance sheet of T ltd

400

Cash

10

100

Debtors

65

11% Deb.

200

Stock

135

creditors

160

Machinery

650

Total

860

total

860
85

APV method
Share holders of T will get 1.5 share in H for every 2 shares. Shares of H is valued at MP of Re180 per share. Debentures holders will get 11% for the same amount External liabilities are expected to be settled at Re 150 lacs. Dissolution expenses @ 15 lacs. To be met by acquiring company. projected FCFF for 6 years.

Year end 1 2 3 4 5 6

Re 150 200 260 300 220 120 86

APV method
FCFF of T is expected to grow @ 3% after 6 years Cost of capital @ 16% Unrecorded liability Re 20 lacs Advise the company regarding financial feasibility of acquisition. Cost of acquisition if FCFF is likely to grow TV6 = FCFFt (1+g)/(Ku- g) If FCFF is likely to decline FCFFt (1+g)/(Ku +g)
Equity (3,00,000 x 180) 11% debentures External liabilities Un recorded liability Dis.Exp.

Re 540 200 150 20 15

Total

925
87

APV method
Terminal value TV6= FCFF6(1+g)/ ( Ku Kg) = Re 120 lac (1.03) / (0.16 0.03) = Re 950.77 lac PV of TV = 950.77 x 0.410 = Re 389.82 lac
Yr end FCFF PV@ 16% Total PV

1 2
3 4 5 6 Total

150 200
260 300 220 120

0.862 0.743
0.641 0.552 0.476 0.410

129.30 148.60
166.66 165.60 104.72 49.20 764.08
88

Tax saving due to interest


Amount of debt ( 11% debentures) Re 200 lacs Amount of interest Re 22 lac Tax saving Re 7.7 PV of tax shield (7.7 /.11) = APV of T ltd 1.PV of FCFF = 2. PV of TV = 3. PV of tax shield = Total APV = Less cost of acquisition = NPV = Acquisition is viable.

764.08 389.82 70.00 1223.90 925.00 298.90


89

Continuing value
Continuing the same example free cash flow of T ltd is expected to grow at 3% after 6 years. Cost of capital decided at 13% (16-3)

90

Continuing value
Equity (3,00,000 x 180)

Re 540 200 150 20 15 925


91

11% debentures External liabilities Un recorded liability Dis.Exp.

Total

Continuing value
Year end 1 2 3 4 5 6 Total FCFF 150 200 260 300 220 120 PV@13 0.885 0.783 0693 0.613 0.543 0.480 Total PV in Re 132.75 156.60 180.18 183.90 119.46 67.60 830.49
92

Continuing value
Tv6 = FCFF6(1+g)/(ko-g) = 120(1.03)/(0.13- 0.03)=Re 123.6/0.1 = Re 1236 lacs PV of FCFF (1-6) Re 830.49 PV of CF after 6 yrs Re 593.28 Less cost of acquisition Re 925.00 NPV Re 498.77 NPV is positive
93

Continuing value
Would your decision change, if FCFF after 6 years (forecasted period) assumed to be (a) constant &(b) decline by 10% . TV = FCFF6/ko = 120/0.13 = 923.08 PV = 923.08 x 0.480 = 443.08 PV of FCFF 830.49 PV after 6 years 443.08 Less cost of acquisition 925.00 NPV 348.57
94

Continuing value
If decline by 10% TV = FCFF6(1-g)/(ko +g) = Re 108(120 x90) /(0.13+0.10)= 469.57 PV = 469.57 x 0.480 = 223.59 PV of FCFF 830.49 PV after 6 years 225.39 Less cost of acquisition 925.00 NPV 130.88
95

Exercise
Banindar software international Revenues - Re 20 lakhs EBIT - Re 2 lakhs Debt Re 10 lakhs Interest (pre tax) Re 1 lakh Book value of equity - Re 10 lakhs (MV is 3 times of BV) Average Beta of publicly traded firms 1.30 Average debt equity 0.2 ( based on market value of equity) Market value of these firms on an average are 3 times of the book value of equity Tax 35% Capital expenditure during the last year Re 1 lakh which is twice the depreciation charge in the last year. Both the items are expected to grow at the same as revenues for the next 5 years and to off set each other in steady state. Revenue growth @ 20% p.a. for next 5 years and 5% p.a. after that. Net income is expected to grow @ 25% p.a. for next 5 years & 5% p.a. after that. T-bill rate (365 days) 5.5% p.a. Return in the market 11% Calculate cost of Equity/cost of capital /FCFF/FCFE
96

Exercise solution
Unlevered Beta for firms in the same business. = 1.30(1+0.65 x 0.2) = 1.15. D/E ratio 10/30= 33.33 %(estimated market value of equity) New levered Beta for similar firms = 1.15 x (1+0.65x 0.3333) = 1.40 New cost of equity = 5.5% (1.40 x 5.50%) = 13.20% Pre cost of Debt - 10 % After tax cost of debt = 10% (1-0.35) = 6.5% cost of capital = 6.5% (0.25) + 13.2% (0.75) = 11.53% 97

Exercise solution - FCFF


1 EBIT -EBIT Tax - Capex depre FCFF Terminal Value * 3.3395/0.11530.05= 52.06 2.40 1.56 0.60 0.96 2 2.88 1.872 0.72 1.152 3 3.46 2.249 0.86 1.389 4 4.15 5 4.98 TV 5.23 3.3995 0.00 3.3995

2.6975 3.237 1.04 1.24

1.6575 1.997 *52.06

98

FCFF
0.96/1.1153+1.152/1.1153^2+1.389/1.1153^3+1.6575/1.1153^4 + 1.997/1.1153^5 = 0.96/1.1153+1.152/1.70+1.389/2.42+1.6575/3.07+1.997+52.06/3.65 = 0.861+0.678+0.574+0.54+14.81= Re 17.463 lakhs Value of equity = 17.463- 10.00 = 7.463 lakhs

99

FCFE

Net Income Less (capex depre) X(1-D/E) FCFE

0.75 0.45

0.94 0.54

1.17 0.65

1.46 0.78

1.83 0.93

1.98 0.00

0.30

0.40

0.52

0.69

0.90

1.98

TV

20.41
100

FCFE
TV of equity = 1.98/(0.132-0.05) = Re 24.146 lacs = 0.30/132+0.40/132^2+0.52/132^3+0.69/132^4+0.90+20.41/132^5 = 0.30/132+0.40/1.664+0.52/2.353+0.69/2.962+25.046/3.50 = 0.265+0.240+0.221+0.233+7.156 PV = Re 8.115 lacs

101

Value - caution
Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business is teetering on the verge of collapse? In 1998, when Kmart's share price was downtrodden, it became a favorite of some investors. They couldn't help but think how downright cheap the shares of the retail giant looked against those of higher-valued peers Walmart and Target. Those Kmart investors failed to see that the business's model was fundamentally flawed. The company's earnings continued to fall and, overburdened with debt, Kmart filed for bankruptcy in 2002. Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or, like Kmart, the company might have intrinsic shortcomings that justify a lower 102 multiple.

Valuations - Caution
It is only future estimate. Based on data which may not happen due to uncertainty. Valuation may be quantitative but based on subjective judgment. Eg. Discount rate. Valuation is time specific. E.g. TATA CORUS deal which has taken place when the market was at its peak. Market value versus estimated value. Under or over valuation. Collective wisdom (market) versus individual wisdom.

103

104

THANK YOU

105