Valuation

Date: 9 July 2006

Prepared: Best Practices Team
OVERVIEW OF SHAREHOLDER VALUE
CREATION
Investment
Decisions
Operating
Decisions
Financing
Decisions
Working capital;
facilities;
Programs
Price, volume
and cost trade-offs;
Cost effectiveness
Debt, equity
leverage
payout
Life, cycles;
competition
Net Cash Flow
from Operations
Discount rate
Cost of Capital Capital markets
Shareholder
value
Dividends Capital gains
The manager
The investor
What is Value?
Value as a term has many meanings and is used to
indicate actual, appraised, book, break-up,
carrying, real, reproductive, depreciated, fair, face,
fair market, going concern, insurable, intangible,
intrinsic, liquidating, market, residual, sound and
true value.
Our View of Value
In the context of a firm, value commonly refers to
either the value of the assets (book, market, or
liquidation) or the value of an income stream
(dividends, earnings, cash flow).
The value of a income stream (cash flows) is a
rationally determined and economic estimate of
future earning potential of the firm.
Why value value?
DCF is the best metric for corporate
performance
Shareholders maximize their own claims,
simultaneously maximize everyone elses
claims.
Corporate failure; capital flows away
Shortcomings of Accounting Numbers
Earnings
Alternative methods of accounting may be employed
Investment requirements are excluded
Time value of money is ignored
ROI
ROE
Impact of Accounting Policies
Assumed no tax, no interest
Policy A Policy B
Years 1 2 1 2
PBDIT 400 600 400 600
Depn. 200 200 400 100
PBIT 200 400 0 500
Cash flow 400 600 400 600

Impact of Time Value of Money
Case 1
Sales 200
Optg. Exp. 170
PBIT 30
Tax 12
PAT 18
Value = 18/0.12 = 150
Impact of Time Value of Money
Case 2
Sales 220
Optg. Exp. 187
PBIT 33
Tax 13.20
PAT 19.8
Value = 19.8/0.12 = 165 - 15 (Inv) = 150
Earning Up; Value constant
Impact of Time Value of Money
Case 3
Sales 240
Optg. Exp. 206
PBIT 34
Tax 13.60
PAT 20.4
Value = 20.4/0.12 = 170 - 30 (Inv) = 140
Earning Up; Value Down
Approaches to Valuation
Models of Valuation
Firm
Dividends
FCF to Equity
Equity
Claimholder
Steady State
Two Stage
Three Stage
Growth Pattern
DCF Models
Fundamental
Comparable Firms
Regression
Approach
P/E Ratios
P/BV Ratio
P/Sales Ratio
Multiples
Relative Valuation Models
Equity
Natural Resource
Product
Option Pricing Models
Valuation Models
Some statements people make
about Valuation
True or False? Why?
Valuation is objective
A well researched and well-done valuation is
timeless
A good valuation provides a precise estimate of
value
The more quantitative the model, the better is the
valuation
Some statements people make about
Valuation (contd)
The market is generally wrong
The product of valuation -- value -- is what
matters; the process of valuation is not important
DISCOUNTED CASH FLOW APPROACH
Explicit forecast period
Continuing value period
n n
n
k
CV
k
CF
k
CF
k
CF
) 1 ( ) 1 ( ) 1 ( ) 1 (
Value
2
2 1
+
+
+
+ +
+
+
+
=
STEPS IN A DCF VALUATION
Forecasting free cash flow
Estimating the cost of capital
Estimate the continuing value
Calculating and interpreting results
Free cash flow
Total after tax cash flow generated by the
company that is available to all providers of
capital
Free cash flow is generally not affected by the
companys capital structure
Free Cash Flow Calculations
EBIT
Less Tax on EBIT
Gives Net Operating Profit less adjusted taxes
(NOPLAT)
Add Depreciation
Gives Gross Cash Flow
Free Cash Flow Calculations
Estimated Gross investment
Capital Expenditures
Investment in working capital
increase in other assets
Investment in goodwill
Gross cash flow less Gross investment
Gives free cash flow to the firm
Free cash flow from other side
Change in excess marketable securities
Less: after tax-interest income
Add: decrease in debt
Add: after tax interest expense
Add: dividends
Gives Total financial flow
Thumb rule
Free cash flow = Total financial flow
Continuing value forecast
Cash Flow Estimation
2003 2004
EBIT 1430 1480
Add: Goodwill
Amortization
20 20
Adjusted EBIT 1450 1500
* Provision for tax 495 4276
- Tax shield on
interest income
7 7
+ Tax shield on
interest expense
213 181
+ Change in
Deferred tax
20 100
Tax on EBIT 681 500
Cash Flow Estimation
2003 2004
+ Depreciation 387 400
Gross Cash Flow 1156 1400
+/- Change in NWC -123 -150
- Capex 587 600
-Change in
Investment in OA
30 50
Total Capex +NWC -740 -800
Net Cash Flow 416 600
STEPS IN A DCF VALUATION
Forecasting free cash flow
Identify components of free cash flow
Develop integrated historical perspective
Determine forecast assumptions and scenarios
Calculate and evaluate the forecast
Developing integrated historical perspective
Analysing historical free cash flow statements,
supported by Income Statements and Balance
Sheets of previous 5 to 10 years
Analysing the rate of return on invested capital
over historical period
Analysing the historical investment rate and its
implications
cont.
Drawing a conclusion about the sustainability of
the companys rate of return in excess of WACC
Determine forecast assumptions and
Scenarios
Determine the overall structure of the forecast
Develop relevant scenarios
Developing a point of view about a forecast for
each variable
Deciding on the length of forecast
A Story
Demand is increasingly rapidly because of
changing demographics, yet prices will remain
stable because of the competitive structure of the
industry. Given the companys competitive
position, it should be able to increase its market
share somewhat, although profitability will remain
constant.
Forecast
Build the revenue forecast. This should be based on
volume growth and price changes.
Forecast operational items such as operating costs,
working capital, PP&E by linking them to revenues or
volumes.
Project non-operating items
Project the equity accounts. Equity should be equal to last
years equity plus net income and new share issues less
dividends and share repurchases.
Forecast
Use the cash and/or debt accounts to balance the
cash flows and balance sheet
Calculate the ROIC tree and key ratios to pull
elements together and check for consistency
Consistency and Alignment
Is the companys performance on the value drivers
consistent the companys economics and industry
competitive dynamics?
Is the revenue growth consistent with the industry growth?
If the companys revenue is growing faster than the
industrys, which competitors are losing share. Will they
retaliate? Does the company have the resources to mange
the rate of growth?
Consistency and Alignment
Is the return on invested capital consistent with the
industrys competitive structure? If the entry barriers are
coming down, shouldnt expected returns decline? If the
customers are becoming more powerful, will margins
decline? Conversely, if the companys position in the
industry is becoming much stronger,should you expect
returns to increase? How will the returns look relative to
competition?

Consistency and Alignment
How will technology affect the returns? Will they
affect risk?
Can the company manage all the investments it is
undertaking?
STEPS IN A DCF VALUATION contd
Estimating the cost of capital
Develop target market value weights
Estimate the cost of equity
Estimate the cost of non equity finance
COST OF CAPITAL
WACC
k = k
e
* w
e
+ k
d
* (1-t) * w
d
Target Weights
Why target weights rather than year-to-year
weights?
Lumpiness of financing
Solves problem of circularity
Target Weights--How do I take care of:

Debt financing
Straight debt
Variable rate debt
Leases
Option features
Swaps
Foreign currency obligations
Target Weights--How do I take care of:

Equity linked/hybrid
Warrants and ESOs
Convertible securities
Target Weights--How do I take care of:

Equity
Target Weights--How do I take care of:

Preferred
Cost of Equity
Gordons (Dividend Discount) Model
Capital Asset Pricing Model
Gordons Model
k
D
P
g
e
= +
1
0
Value of Stcok and Expected Growth
0
50
100
150
200
250
300
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Expected Growth Rate
S
t
o
c
k

V
a
l
u
e
Measuring Growth
Analysts Forecast
Historical Time Series Approach
Sustainable Growth Model
Analysts Forecast
Specialised services like ValueLine provide
growth estimates
Own estimates
Historical Time Series Approach
Arithmetic or geometric growth rates
Regression
Negative earnings
Percentage change in EPS =
(EPS
t
-EPS
t-1
)/Max(EPS
t
, EPS
t-1
)
Or
(EPS
t
-EPS
t-1
)/| EPS
t-1
|

Sustainable Growth Model
g = (plowback ratio) * (return on equity)

or

g = (plowback ratio) * (ROA +
D/E*(ROA-i(1-t)))
Sustainable Growth Model
g = (plowback ratio) * (ROA +
D/E*(ROA-i(1-t)))
This implies that:
ROE = (ROA + D/E*(ROA-i(1-t)))
How?
Sustainable Growth Model
Lets define:
ROA = [Net Income (NI) + Interest(I)*(1-t)]/
BV of assets
D/E = BV of debt/BV of assets
i = Interest expense on debt/BV of debt
T= tax rate on ordinary income
Sustainable Growth Model
Now, by substitution:
ROA + D/E*(ROA-i*(1-t)) =
[NI+I*(1-t)]/ (D+E) + D/E *{[NI+I*(1-t)]/ (D+E)
I(1-t)/D }
On simplification this term equals
NI/E or ROE

Value of past growth
Variability

Size of firm
Cyclicality in economy

1
) (
1

=
n
g g
n
t
t
t
o
Value of past growth
Change in fundamentals
Business mix, Project choice, Capital structure,
dividend policy, market forces, government regulations
Quality of earnings
Information used by analysts in making
forecasts
Firm specific public information
Macroeconomic factors
Information revealed by competitors regarding
future projects
Private information about firms
Public information other than earnings
Individual Product line forecast



)]) 1 ( [ ( t i
E
D
b g
jt jt jt jt jt
= t t t t
j line pdt for year t in rate growth =
jt
g
j line pdt for year t in margin profit =
jt
t
j line pdt for year t in over asset turn =
jt
t
Other terms have usual meanings
k R E R R
e f m f
= + | ( ( ) )

CAPITAL ASSET PRICING
MODEL
CAPITAL ASSET PRICING MODEL
Key issues:
Risk-free rate
Risk premium
Arithmetic mean vs geometric mean
Beta estimation issue
Choice of estimation period
Choice of return interval
Choice of market index
Tendency to regress to one
Accuracy measurement
Means Controversy
Suppose you bought a share for Rs 100. Next year
the price of the share went up to Rs. 200 and in the
subsequent year fell down to Rs. 100. What is
your rate of return?
Arithmetic return = [+100% +(-)50%]/2 = 25%
Geometric return = [100/100]
(1/2)
1 = 0%
Means Controversy
100
200
400
50
25
100
Prob. of up or down is 0.5
Div=0
Means Controversy
100
200
400 0.25 =100
50
25 0.25 = 6.25
100 0.50 = 50
Expected Price = 156.25
This is same as 100(1.25) (1.25) =
156.25
Adjustment for tendency to regress to one
Method: One-third of distance to goal line
Atulyas beta is 1.48
Adjustment |(Raw beta 1)|/3
Thus adjusted beta = 1.48 [|(1.48-1)|/3]
= 1.32
If Meghanas beta is 0.52. Then adjusted beta is?
Adjustment for tendency to regress to one
Method: One-third of distance to goal line
Meghanas beta is 0.52
Adjustment |(Raw beta 1)|/3
Thus adjusted beta = 0.52 + [|(0.52-1)|/3]
= 0.68
Precision weighted peer group beta
Company D/V
MV
Basis
MV of
Equity
Est.
Beta
Std. Err.
Of beta
A 0.25 200 1.20 0.35
B 0.00 1150 0.80 0.20
C 0.14 850 0.85 0.25
D 0.36 500 0.75 0.46
Tax rate is 20%
Precision weighted peer group beta
Compan
y
Unleverd
beta
Precision of
beta
Precision
weight
Weight*
Beta(UL
)
A 0.947 8.1632653 0.151 0.143
B 0.800 25 0.464 0.371
C 0.752 16 0.297 0.223
D 0.517 4.7258929 0.88 0.045
Average = 0.782
Cost of Debt
Cost of debt is not the coupon rate
Cost of debt is the yield to maturity
Yield to Maturity (YTM)
is that discount rate that makes the PV of the
promised future cash flows equal to the current
market price of the bond (IRR)
the rate of return to an investor if she holds the
bonds to maturity and if the coupons are
reinvested at the YTM
YTM computation
Pr
( ) ( )
ice
Coupon
r
FaceValue Coupon
r
i
i
n
=
+
+
+
+

1 1
Cost of Capital to GOI
Source of
Funds
Amt
(Rs. Crs.)
Cost
Assigned
Weighted
Cost
Taxation 4044 10 40440
PSE
Surplus
1431 10 14310
Loans,
Small
Savings
and Debt
6538 8 39228
External
Assistance
2087 4 8348
Deficit
financing
2060 15 30900
Total 16160 133226
Weighted Cost = 133226/16160 = 8.24% (approx.)
STEPS IN A DCF VALUATION contd
Estimate the continuing value
Determine the relationship between continuing value
and DCF
Decide forecast horizon
Discount to the present
STEPS IN A DCF VALUATION contd
Estimate the continuing value
Select appropriate technique
Select forecast horizon
Estimate parameters
Discount to present
Deciding on the length of forecast
Explicit forecast period
Continuing value forecast
STEPS IN A DCF VALUATION contd
Calculating and interpreting results
Develop and test results
Integrate results within decision context
STEPS IN A DCF VALUATION contd
Tests
Is th result consistent with the value drivers implicit in
forecast?
Resulting value vs Market value?
Do any results require special explanations?
Are the financial aspects achievable and desirable?
STEPS IN A DCF VALUATION contd
Interpret
Clearly identify value drivers and key assumptions
How much the variables can change without changing
decisions
Likelihood of changes in key assumptions
Environment, competitive structure, internal competence
Develop alternative scenarios
Final points
Avoid short-cuts
Avoid hockey sticks
Be realistic about synergies
Off Balance sheet items
Thank you