Introduction

CHAPTER I
INTRODUCTION

1.1 Introduction

“Price is what you pay, value is what you get” said Warren Buffet one of the world’s
greatest investors. Intrinsic value is the strength of a stock and greater this value, the
more it is a safe bet from the point of view of investment.

The vision for the stakeholder is that a business should be measured by its true
value and use true costs and true profits in its internal and external reporting. Profit and
loss, Performance and Value creation should be redefined and stock prices should
reflect the true value, profits and costs of the company.

Valuation is a method of estimating the economic value of an asset or capital.

The valuation of business encompasses a set of procedures used to estimate the
economic value of an owner’s interest in the business. The premise of valuation is that a
reasonable estimate of value for most of the assets can be made and that the
fundamental principles that determine the value of all types of assets remain the same.

Valuation also provides a road map for increasing a firm’s future growth,
helping to recognise what adds to its worth by improving future business decisions.
Managers who focus on shareholder value will create healthier companies than those
who do not. Healthier companies will in turn lead to higher economies, more career and
business opportunities for individuals and higher standards of living.

Today, India is the biggest among the emerging market economies. The Indian
stock market holds a place of prominence with bourses such as Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE). The BSE is one of the world’s oldest stock
exchanges with a total number of companies double that of the London Stock Exchange,
NASDAQ and NYSE companies quoted in its market today. The National Stock
Exchange is the best in terms of sophistication and advancement of technology. Several
studies have proved the inefficiency existing in the stock markets. Though the stock
markets are rapidly moving towards efficiency and there is a lower possibility of making
abnormal gains in the process, still inefficiency persists. The implication of inefficiency is
that companies with low true values may be able to mobilise a lot of capital while
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companies with high true values may find it difficult to raise capital. This disrupts the
investment scenario in our country and also has an impact on productivity. The major
problem for the economy is that the investment funds are not appropriately channelized to
where they are mostly useful. This resource misallocation in the long run is destructive as
it would hinder the sustainable development of the economy. In this regard, the current
study highlights the need for a proper allocation of resources as the stock prices should
match the intrinsic value of the stock. In other words, the investors should pay the prices
which reflect the true worth of the stock thereby channelizing funds to where it can be
most effectively used.

Economic reforms after 1991 opened the gates to foreign competition in India.
Multinational Companies (MNCs) through inflows and Foreign Direct Investment
provided most of the technological inventions, development and growth.In 2014, India
was the tenth largest GDP economy which stood tenth in terms of factory output and
fifteenth in service output. The McKinsey Global Institute reported in 2010 that there
were nearly 8,000 companies having annual revenues of more than one billion dollars
and three-fourths of these are based in developed countries. This scenario would
undergo a transformation over the next 15 years. By 2025, these multinational
Companies would double to 15,000 and seven out of ten of these would have their
corporate headquarters located in emerging countries like India, China and South Korea.
In this backdrop, it becomes imperative to focus on how these foreign entrants create
value as against their domestic counterparts in our country.

A new unfolding pattern has radically reshaped the global business landscape.
With the divergence of economies, global growth is poised to accelerate. Securities and
Exchange Board of India (SEBI) has relaxed the norms for MNCs in India. Two
decades ago the Foreign Direct Investment (FDI) norms had an upper cap on the
maximum ownership by a foreign entity, these foreign entities could not have a hundred
percent subsidiary of their business entity in India. This requirement led many foreign
companies to list their subsidiary in India.

In the present era of globalisation, privatisation and liberalisation enormous

growth opportunities are available for the corporate sector in India. But the last few
years has seen a change in the FDI policy in many sectors with restrictions on

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ownership only in certain critical sectors. So the directive that made listing compulsory
was no longer applicable. Many MNCs like Philips, Panasonic, Ray Ban, Otis and
Carrier which were once listed on Indian bourses had been delisted. MNCs had enough
support from parent company and did not require financing from the Indian capital
market. This deprives Indian investors of investment in these profitable companies and
getting benefits there from.

The problem arises when stock markets are bearish; and when all the stock
prices fall. The suppressed market conditions leads to pessimism among the investors
who want to get out of equities. Most of the investors in this pessimistic environment do
not differentiate between good and bad investments. Promoters of MNCs usethis kind of
undervaluation to their advantage and acquire the remaining shares at a lower valuation
and applied for delisting. In the long run, the minority interest is affected as they stand
to lose the possible gains that could be made from MNCs. In the last few years several
MNCs like Hindustan Unilever Limited and GlaxoSmithKline Consumer Healthcare
Limited had made open offers to minority stakeholders to raise their stakes in Indian
subsidiaries. The Indian rupee is still favourable to open offers. The Business Standard
reported that in the first half of 2013, the open offers went up to a six year high, worth
Rs. 37,460 crores as compared to Rs. 1,721 crores in the previous year. Moreover it is
also necessary in the present era of globalisation to evaluate whether these global giants
have larger value creations than the traditional companies in India. Hence, valuation
methods enable the investors to stay invested considering their stock’s intrinsic value
and make gains in the long run.

1.2 VALUATION AND ITS ROLE IN MANAGERIAL DECISIONS

In an efficient market, the market price is the best estimate of value. But when
inefficiency prevailed in the market, it was assumed to make some mistakes in assessing
value and these mistakes can occur over entire sectors and sometimes even the entire
market. Assets were incorrectly priced over time and are assumed to get corrected
automatically with the receipt of new information. Valuation acts as a catalyst needed to
move price to value as needed for an active investor who makes logical decisions of
investment with long term horizon. Hence, using valuation would allow the market to
correct its valuation mistakes and for price to revert to its true value.

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 Value creation is the ultimate measure of performance. It is essential to know to
what extent a business in its current performance creates value. For analysing a firm, it
is imperative to know the type of assets it owns, the value of these assets and the degree
of uncertainty about this value. Though the accounting statements did a reasonably good
job of categorising the assets owned by a firm and assessment of the value of these
assets, they largely fail to report the uncertainty about the asset value. The accounting
view of value of an asset is to a large extent grounded in the notion of historical cost,
where loss in the value of an asset is associated with the ageing of the asset. In
comparison, a valuation technique is able to make reasonable estimates of value by
quantifying future benefits with reasonable precision, as it treats an asset as a resource
that has the potential to generate future cash inflows or to reduce future cash outflows.
Traditional financial analysis uses tools like return on investment, return on equity and
earnings per share based on Income Statement and Balance Sheet. These analyses are
based on arbitrary assumptions which fail to consider cost of capital and timing of
returns. But the current valuation techniques were inbuilt with factors as cost of capital,
risk, present value of future returns, growth and reinvestment needs of the firm.

There are a range of reasons that business owners require for valuation like:

 commencing a sale process

 deciding the target price in a takeover or merger and acquisition

 resolving shareholder disputes

 determining tax obligations

 solving litigations

 accessingexternal sources of funding

 planning and future decision making.

Valuation is also of immense utility for Equity Research Analysts whose job is
to follow the movement of stock in sectors and make recommendations on the most
undervalued and overvalued stocks in a sector. Its use to Equity Portfolio Managers is
substantial as they had to be fully invested or stay close to fully invested. The purpose
of any valuation method is then to provide the true and fair value of the asset.

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 Valuation acts as a benchmark for comparison to the owners to see how well the
business is operating as compared to other similar businesses in the same industry.
Valuation also serves to raise expansion capital through lending institutions and venture
capitalists. It helps in valuing company’s stock for the development of Employee Stock
Option Scheme (ESOP) or bonus stock. Buyback of shares could happen only with the
use of valuation. Also valuation helps to determine the price of an Initial Public
Offering (IPO).

The valuation of firms is fundamental for identifying and stratifying the main
factors affecting value. Valuation helps in identifying and strengthening businesses
which are sustainable. It enables the management to make investment and strategic
decisions effectively. Further, more sustainable companies are recognised and rewarded
leading to a faster growth of the economy.

Inefficiencies in the market could even reward or punish managers on the

performance of the stock. Thus, a firm whose stock price has gone up is viewed as creating
value, and if the stock price has declined it has destroyed value. Hence, compensation systems
based on the stock prices would also go wrong. Thus, a firm may see its stock prices go up
and its top management rewarded, even as it has destroyed value. Today, the compensation
systems based on stock prices like stock grants and warrants has become a standard
component of most management compensation packages. The management with a focus on
the long term shareholder creation, rewards on the basis of the company’s Economic Value
Added (EVA).

1.3 BACKGROUND OF THE STUDY

Trading in the stock was mostly based on the intuition of the investorsprior to the advent
of computers. Also investors generally found it easier to follow a stock and buy a
popular stock. As trading flourished, people searched for tools and methods that would
increase their gains and minimise the risk. One major reason why the importance of
valuation had been created is that the activities in the stock markets have increased.
With many institutions and investors heavily invested, it called for an ever increasing
sophistication of tools available to estimate the value of firms in the stock markets.
When the book values of assets was more static and did not indicate the future potential,
it led to undervaluation of companies with high growth potential. Distortions in

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valuation based on financial statements were possible as earnings can be inflated in the
short term due to the fact that accounting profits were subjective. Here, the importance
of free cash flows was stressed as free cash flows were ranked first in the order of
importance in comparison to accounting variables (Imam et al., 2008). Hence, the
current study emphasises the importance of carrying out the valuation of firms using
free cash flowin the FCFF (Free Cash Flow to the Firm) method.

Information about a stock is normally incomplete, complex, uncertain and

vague, making it a challenge to predict the future economic performance. Hence, share
prices do not reflect the true value of the stocks. According to Dr.C.Rangarajan, Former
Governor of RBI, “Share price in India tends to be considerably influenced by short
term technical consideration and speculation.” Research evidence on the Indian stock
market shows that possibilities of undervaluation and overvaluation exist for sizeable
amounts of stocks. The current study makes a comparative analysis of the extent of
variation in stock prices from the intrinsic value under the three methods of FCFF,
EVA and RV(Relative Valuation).

Preference to income approach than the asset approach was given in the Indian
valuation context. The dominance of profits for valuation of share price was emphasised
in Mc Cathie’s Case as it was said that “the real value of the shares will depend more on
the profits the company is making and should be capable of making, having regard to
the nature of the business, than upon the amount which the shares would realise
on valuation.”

The Reserve Bank of India had prescribed DCF (Discounted Cash Flow) as the
valuation method in the case of FDI (Foreign Direct Investment) investments after 21 st
April, 2010. In India, RBI is the only regulator which has mandated the use of DCFin
the case of ODI (Overseas Direct Investment) transactions and also for the valuation of
shares for convertible instruments. It also recommended the comparable transaction
method and PORI (Price of Recent Investment).

Valuation stresses the need for firms to generate positive earnings and sales
growth and also provide an adequate return on thecapital invested. The current study
uses returns, costs of capital and the present value concept in calculation of firm’s value
both under FCFF and EVA methods. Valuation enables investors to verify values rather

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than depend on brokers reports. The current study simplifies valuation with the use of
calculated multiples in the technique of Relative Valuation.

It is proved by the earlier researchers, that there was only a weak correlation
between how a firm performed by earnings and how the market appeared indifferent to
such growth in assigning a firm’s Price/Earnings (P/E). The goal of any valuation
method is to remove these distortions and to provide comparability over time, firm and
industries to meet the expectations of providers of capital. The current study reduces
such distortions by comparing the intrinsic values representing the earnings of the firm
with the actual market price.

Valuation is useful in circumstances such as mergers and acquisitions. Valuation

in an emerging market like India is gaining importance for joint ventures, mergers and
acquisitions, restructuring and value based management. The total number of merger
and acquisition deals of Indian companies in 2014 rose to 1177, the highest ever in a
decade and it was expected that the momentum would pick up in the future years. The
significance of valuation methods to determine the target price and help in timing the
sale of the business is invaluable in such circumstances. Business valuation could impart
insights into a company’s strengths and weaknesses. The current study lays thrust on the
methodologyto achieve the maximum selling price in an acquisition.

1.4 PROBLEM DEFINITION

The heavy reliance on book value measures such as return on investment, return on
equity and earnings per share are subject to frequent distortions and manipulations by
the management. Investment made on these considerations did not consider present
values, cost of capital and cash flows. The valuation methods used in the study
incorporates these considerations like the use of present value in the determination of
the value of the firm and serves the principal users of the information like Corporate
Executives, Analysts and Money Managers. This kind of valuation provides the
requisite skill of looking at historic and forecasted information in comparison to peers in
the industry to determine whether the company’s stock is overvalued or undervalued.
Accurate valuation of the firm is most important and can be identified by finding
valuation errors. Hence, it is necessary to examine the accuracy and bias of intrinsic
equity prices estimated from the three valuation methods. Valuation errors would reveal

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which method yields a more accurate and unbiased price and would help choose among
the valuation methods.

The primary goal of investment is to earn returns above those made by the
market. In this direction, the study concentrates on the abnormal returns of the stocks to
verify the variables that have an impact on returns. This study would enable to
channelize investments into stocks with potential higher returns in the future.

1.5 RESEARCH QUESTIONS

The premise of this study is structured around the following research questions.

1. Is there any difference in the value of firms obtained by the select methods
namely Free Cash Flow to the Firm Valuation, Relative Valuation and Economic
Value Added and to determine the method that yields value closer to the market
price? Is there a significant difference in firm values of multinational and
domestic firms?

2. How can the values be verified for errors in practice? Can a single valuation
method be superior and lead to an unbiased and accurate price?

3. Do few multiples work better under Relative Valuation than the others?

4. Is the enterprise value of a firm positively affected by various drivers such as

fixed assets, working capital, employees, reinvestment rate, risk, and cost of
capital, return on capital, leverage, cash flow earnings and sales?

5. Are the abnormal returns of the stocks related to the intrinsic value of the stock,
market capitalisation and M/B ratio of the firm?

1.6 OBJECTIVES OF THE STUDY

1. To measure the intrinsic value of shares of the selected companies using select
methods and estimate the valuation errors arising from the implementation of the
select methods and to determine the proximity with the market price.

2. To evaluate the value drivers that signifies the enterprise value of the firm.

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 3. To discriminate the domestic and multinational companies in terms of its value
and abnormal returns and to identify the significant determinants influencing the
enterprise value.

1.7 SIGNIFICANCE OF THE STUDY

In finance, calculation of present values of all cash inflows of the project is considered in
the determination of Net Present Value and this helped decision making on acceptance or
rejection of a project. The same concept could be applied to the firm as a whole where
valuation incorporated the present values of current and future cash flows including the
terminal value of the firm which arises with all future growth and investment. To gauge
the wisdom of investing in a company or a project where all the company’s shares were
acquired required consideration of all aspects of the firm in totality. Value emphasis
should be promoted as a part of corporate culture instead of focusing on certain
performance indicators alone like return on invested capital and growth. Unlike previous
studies with research centred mostly in developed countries, this study is in the Indian
context and aims to analyse the value of the firm through important techniques like FCFF,
EVA and RV. The study also attempts to establish the proximity of the multiples to the
market price.

The intrinsic value of the stock suggests the internal strength of the stock. But it
was not always true that the stock would achieve its intrinsic value in the stock market.
Hence in the current study the valuation of the firm and consequently its intrinsic value
is a technical suggestion to the investors to purchase the shares when they were
undervalued (market price < intrinsic value) and sell the shares when they were
overvalued (market price > intrinsic value).

The methods used to calculate the intrinsic value are verified to check the one that
gives values in proximity to the market price. The study also calculates the enterprise and
price value multiples using the technique of Relative Valuation. The determination of
valuation error is of practical importance. The study examines the accuracy and bias of the
intrinsic equity prices estimated from the three methods. The results would be of help to an
analyst, investor or researcher who has obtained the firm’s financial statements and
forecasts over a time horizon of firm’s earnings and book values. During implementation of
a valuation method, an accounting method which would result in the most reliable intrinsic

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value has to be chosen. The study also tries to establish the impact of various factors on the
enterprise value of the company. The returns on the stock are also compared to the market
index to determine the abnormal returns. The abnormal returns are analysed for its
relationship with the Value/Price (V/P) ratio and also with the size of the company (market
capitalisation) and Market/Book Value (M/B) ratio to evaluate the type of stocks that
provide better returns. Thus, this research would help the management in the structure and
design of the variables like fixed assets, working capital and employees costs.

1.8 APPROACHES TO VALUATION

There are numerous valuation methods which can be grouped under three approaches
to valuation.

• Intrinsic valuation
• Relative Valuation
• Contingent claim valuation

Intrinsic valuation could be further grouped into Discounted Cash Flow (relies
on cash flow) and non Discounted Cash Flow methods (relies on financial variables
other than cash flow). Some of the DCF techniques are Free Cash Flow to the Firm
(FCFF), Free Cash Flow to Equity (FCFE), Adjusted Present Value (APV) and
Dividend Discount Models (DDM). Intrinsic methods determine the value of a firm
using the pertinent factors as, capacity to generate cash flows from its assets in place, its
cost of capital, the expected growth rate of cash flows and the length of the time it
would take to reach stable growth.

Variants of non DCF techniques are Economic Value Added (EVA) and
Economic Profit methods, both being methods based on excess returns. These methods
highlighted how and when a firm creates value. Relative Valuation is based on the
market assessment of comparable firms with standardised measures of value. It reflects
market moods and perceptions better than FCFF and worked best for investors with
short term horizon. The third approach Contingent Claim valuation used Option Pricing
methods to measure the value of assets that has share option characteristics. The idea is
to estimate the correct theoretical price of the option in order to determine its

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overvaluation or undervaluation. Knowledge of when to use a method is a key aspect in
mastering valuation.

1.9 CHOICE OF METHODS FOR VALUATION

A valuation system should also encompass the four main drivers of enterprise value:
profitability, competition, growth and cost of capital.

In the current study,FCFF, RV and EVA are adopted as they are frequently used
in the Indian context.The study evaluates each of the methods by means of comparative
analysis usingmarket prices as a benchmark for identifying over and under valuation of
the firm’s stock. The current study chooses the FCFF method as it is independent of
leverage and determines the company’s capability to pay off its debt and equity claims.
With its wide application by companies in India, EVA has been selected for the current
study as one of the methods for valuation of firms. The current study also incorporates
the use of Relative Valuation as a common and convenient tool in the hands of an
investor.

1.10 SCOPE OF THE STUDY

This study is limited to selected MNCs and domestic companies which are listed in the
Bombay Stock Exchange. Listing on exchange is a prerequisite since the stock price
information was needed for calculation cost of equity and also market capitalization.

This study is based on secondary data drawn from Prowess database of Centre
for Monitoring Indian Economy (CMIE). The study is restricted to the companies
selected considering the availability of data. The study has been carried out with three
methods of valuation but can be extended to other methods like Options Valuation,
Dividend Discount Models, and Free Cash Flow to Equity method and Adjusted Present
Value methods.

1.11 Definitions of terms used in the study

The thesis uses many terms and an explanation of the following terms is necessary for
understanding and application of the valuationmethods.

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1. Risk Free Rate (Rfr)

Risk free rate is the rate of interest payable on a long term bond issued by the Indian
Government. The risk free rate is reduced by the default spread for India which is based
on its local currency rate BAA3.

2. Cost of Debt (Kd)

Cost of debt of a company was calculated using the Synthetic default method by adding
default spread based on the company’s rating to the risk free rate. Once cost of debt is
calculated it is computed on after tax basis.

3. Tax Rate

The tax rate used is the tax rate provided by the Prowess database for the respective
domestic and foreign companies. The tax rate in the stable period is taken at a uniform
30 percent.

4. Cost of Equity (Ke)

The study uses CAPM for the calculation of cost of equity capital which is equal to the
risk free rate and Beta times the Equity Risk Premium.

5. Equity Risk Premium (ERP)

Equity Risk Premium is taken from the calculations of Professor Aswath Damodaran,
India’s Equity Risk Premium has been computed with due consideration to the Country
Risk Premium.

6. Free Cash flow (FCF)

Free Cash flows one of the ingredients to calculate the value of the firm represented the
net cash flow of the company including non cash charges as reduced by other planned
expenditure such as capital expenditures and non cash working capital.

7. Non cash Charges

Non cash Chargesare items that affect the income but do not involve the payment of
cash. The non cash charges included depreciation, amortisation and write offs which are
added to arrive at the FCF.The capital expenditures and changes in noncash working
capital representedthe reinvestment needs of the firm for future growth.

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8. Capital Expenditure (CAPEX)

The capital expenditure of the companies includes purchase of fixed assets, increase in
capital work in progress and acquisition or merger of companies and units. For
estimating capital expenditures the study did not distinguish between internal and
external investments.

9. Non Cash Working Capital

Non cash working capital is computed as it has more relevance to valuation. It is the
sum of Inventories and Accounts receivable after the deduction of Accounts Payable.

10. Growth

The annual growth in sales revenue is computed and the growth rate is averaged from
the years 2008 to 2013 and used for forecasting future growth of sales during the
explicit period of forecast for five years.

11. Explicit Period of Forecast

The explicit period of forecast is a period of five years from the year’s 2014 to 2018
which used a higher growth rate of sales.

12. Stable growth

The company is assumed to achieve its stable growth after five years when its revenues
grew at a lower rate not higher than the GDP growth rate of the economy.

13. Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital is the weighted average costs of market value of
equity and book value of debt. The calculated cost for three years is averaged and its
mean used to discount the cash inflows during the explicit period. The cost of capital to
discount the terminal values is calculated by lowering ERP by 1% and cost of debt
before tax by 1%.

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14. Terminal Value

A significant part of the company’s value can be derived from its terminal value which
is calculated during the period of stable growth, discounted and added to calculate the
Enterprise Value.

15. Beta

Beta measured the unsystematic risk of the company. This beta has been unlevered and
levered in the calculation of cost of equity.

16. Enterprise Value (EV)

The enterprise value is the total value of the company that includes the debt and equity
components.

17. Equity Value

Equity value represents the claims of the equity stakeholders by deducting debt and
adding cash and cash equivalents.

18. Intrinsic Value

From the equity value, value per equity share or intrinsic value is computed to be total
equity value divided by the total number of shares.

19. Discounted cash flow (DCF)

DCF techniques estimate the intrinsic value of an asset based on the present values of
cash inflows during the explicit period of forecast and the present value of terminal
value calculated in the last year. The cash inflows are discounted using the cost of
capital reflecting the riskiness of the cash inflows.

20. Free Cash Flow Firm (FCFF)

Free cash flow to the firm is a method which calculates the value of the firm based on free
cash flows representing the total flows to both debt and equity shareholders. The FCFF
method used in the current study has two stages of growth, the explicit period of high
growth and period of stable growth.

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21. Economic Value Added (EVA)

EVA measures the true economic profit and is calculated on the net operating profit
after tax after deducting the costs of all capital.

22. Invested capital

The total invested capital is computed under EVA for each year as equal to the Book
value of Equity Capital and Book value of Debt.

23. Return on Capital

The Return on Capital is equal to earnings before interest and taxes divided by the book
values of capital debt and equity. The Return on Capital (ROC) has to be higher than the
firm’s cost of capital for the enterprise to create a larger value.

24. Reinvestment Rate

The sum of capital expenditures and changes in non cash working capital represent the
reinvestment needs of the firm for future growth. From the above calculation,
depreciation is deducted and divided by EBIT.

25. Relative Valuation(RV)

Valuation of an asset is based on standardised values of similar or comparable assets. To

facilitate comparison the companies are chosen from the same industry. Relative
Valuation of companies had been done using enterprise and equity multiples.

26. Abnormal Returns

The abnormal return for a stock is the excess returns made by each company’s stock
over the market index SENSEX.

1.12 LIMITATIONS OF THE STUDY

The study is restricted to a sample size of thirty two companies due to time and financial
constraints. Non availability of financial information of MNCs in the Prowess database
has been a constraint in the collection of information pertaining to these companies. The

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database provided information on only few MNCs and the need to have parity between
domestic and MNCs restricted the sample size to thirty two. Moreover, these companies
are not required to be listed as per SEBI’s current guidelines due to which pricing
information is unavailable for many of these companies.

The select methods used also require voluminous information which is spread
across twenty five statements for each company. Hence, the restraint on the availability
of secondary data limited the sample size.

1.13 ORGANISATION OF THE STUDY

The first chapter of the thesis describes the need, objectives and scope of the study. The
second chapter provides previous research studies focussed on the area. The third
chapter outlines the methodology for calculation of the cost of capital, the intrinsic
value using the three methods, valuation errors and abnormal returns. The fourth, fifth,
sixth and the seventh chapters analyses the results of the study. The eighth chapter
concludes the study with suggestions and recommendations.

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