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Term V - 2014

Deepak Kapur

tapak7@yahoo.com

Dec-14

Deepak Kapur

statements

Applicable to financial statements prepared post April

1st, 2011

While presentation of financial statements is not a

subject matter of this course, changes introduced have

lead to a problem for analysts in comparing earlier year

statements with current years

Sheer numerical analysis may lead to incorrect

conclusions and hence all analysts must study and

understand the changes introduced in Schedule VI

before comparing financial data across year

Read the summary document sent as soft copy

Annual Reports most exciting reading genre

Is it fiction or non-fiction?

Dec-14

Deepak Kapur

SAME data looks different under the old

and new format of classification

While balance sheet looks very different

there is no difference in reported net

profit

Dec-14

Deepak Kapur

OLD FORMAT

Dec-14

NEW FORMAT

Deepak Kapur

OLD FORMAT

Dec-14

NEW FORMAT

Deepak Kapur

.. intrinsic value, an all-important concept that offers the only

logical approach to evaluating the relative attractiveness of

investments and businesses. Intrinsic value can be defined simply:

It is the discounted value of the cash that can be taken out of a

business during its remaining life. The calculation of intrinsic

value, though, is not so simple. As our definition suggests,

intrinsic value is an estimate rather than a precise figure, and it is

additionally an estimate that must be changed if interest rates

move or forecasts of future cash flows are revised. Two people

looking at the same set of facts, moreover - and this would apply

even to Charlie and me - will almost inevitably come up with at

least slightly different intrinsic value figures.

Warren Buffet

Dec-14

Deepak Kapur

Dec-14

Deepak Kapur

Valuation - Reality

1. We can only estimate a likely range of fair value, never a

precise estimate an endless search for intrinsic value

2. A professional valuation report usually has inherent biases

depending on who is valuing and for whom

3. Uncertainty is a given in business valuation

4. High end quantitative techniques are not necessarily better

valuation models in fact simpler models give better

estimates

5. Herd mentality tends to reinforce biases and perceptions

which may be distant from reality

Dec-14

Deepak Kapur

BUT

Dec-14

Deepak Kapur

The stock market is filled with individuals who know the

price of everything, but the value of nothing."

Common Stocks And Uncommon Profits

PRICE

Dec-14

Deepak Kapur

10

Our aim is to put a fair value to the business we are valuing

and not second guess what someone else will pay

Dec-14

Deepak Kapur

11

PV Basics

1. PV of series of cashflows at time t 0

CFn

CF1

CF2

.

.

.

(1 r )1 (1 r ) 2

(1 r ) n

2. PV of a constantperpetuity at time t

CFt 1

r

first year which should be

CFt 1

used

numerator. This

3. PV of a growing perpetuity at time t

........................................

....in.(I)

rg

formula can also be written

as [CF0*(1+g)]/(r-g) where

1 CF0 is the cash flow of just

expected to grow by g

4. PV of a constant year end annuity; PV(A, n, r) A

r

(1 g) n

1

n

(1

r)

5. PV of a growing year end annuity; PV(A, n, r, g) A(1 g)

r-g

Dec-14

Deepak Kapur

....(II)

12

Testing PV Basics

A business currently earns $10mn and this is expected to grow at

5% per year for the next five years and thereafter remain constant

at $15mn per year for another 5 years. From the 11th year onwards

earnings are expected to grow at 5% till perpetuity. Find the value

of the business by discounting earnings at 10%

(1 (1.05 / 1.1) 5 )

1

(1 (1 / 1.1) 5 )

10 * (1.05 )

* 15

n

0.1 0.05

0

.

1

(1.1 )

1

(1.1

15 * (1.05 )

(0.1 0.05 )

10

What is the value of m? 11 or 10 (Ans: 10_)

Dec-14

Deepak Kapur

13

A business earned Rs. 5 mn as free cash flow in the just

concluded financial year. What is the PV of a business if

cash flows are expected to be 10 mn each year from next

year onwards till perpetuity

For the above question, what would be the value of the

business if the business had earned 10 mn in the just

concluded financial year instead of 5 mn.

A business is expected to generate 10 mn in free cash

flow next year, 20 mn the year after that and thereafter

the free cash flows will grow at 10% perpetually. What

is the present value of the business?

Dec-14

Deepak Kapur

14

justice to valuation

If I were teaching a course on investing, there would simply be one

valuation study after another with the students trying to identify the

key variables in that particular business and ... evaluating how

predictable they were. because that's the first step..

W.E.B

and their effect on cash flow. This is the key to good

forecasting.

It is not possible to do justice to valuation without

understanding the basic characteristics of the business

Remember, firms are just an aggregate of securities and

projects

Dec-14

Deepak Kapur

15

and various uses of the word value

Dec-14

Deepak Kapur

16

Capital refers to amount invested to run a business.

It could be capital raised from owners (or equity

holders) or from lenders

Capital of Owners as shown in books of accounts also

referred to as: Networth / Shareholders Equity / Equity /

Book Value of Equity

Capital from lenders and owners combined as shown in

books of accounts referred to as: Invested Capital /

Total Capital / Book Value of Debt+Equity / Book Value

of Enterprise

Dec-14

Deepak Kapur

17

Capital

Networth (NW)*

If Calculated From Equity and Liability Side = Share Capital + Reserves

& Surplus

If Calculated from Asset Side = All assets Non-Current and Current

Liabilities

Capital Employed or Invested Capital**

If Calculated From Equity and Liability Side = Networth + Debt (Long

and Short Term) + Short term portion of Long term debt (we have to look

at details of other current liabilities to get this figure)

* Many analysts include deferred tax liability (DTL) as part of NW. This is true is cases

where DTL is expected to exist for a very long time. Otherwise DTL should be part of

Long Term Debt. But ensure it is treated as either debt or equity and not left out.

** When investors look to calculate return on total capital, the total capital they take is

equity plus interest bearing debt (including short term portion of long term debt).

Liabilities which arise in the course of business (long or short term) are not part of

invested capital. Hence Current Liabilities (CL) and other long term liabilities are not

included as part of it other than short term portion of long term debt.

Dec-14

Deepak Kapur

18

Calculate

1. Net worth

2. Invested Capital /

Total Capital

3. Assume: Short

Term Portion of

Long Term Debt is

zero unless

otherwise specified

Dec-14

Deepak Kapur

19

Networth = 111 + 1126 = 1237

Invested Capital = 1237 + 289 + 854 + 0 = 2405

(in this course we will neglect DTL for the purpose of

calculating Total Capital)

Dec-14

Deepak Kapur

20

EQUITY:

As against Book Value of Equity which shows the amount of

equity (a.k.a. Networth )as recorded in the books of accounts,

market value of equity refers to how much the market is valuing

the equity if the company is listed.

Market value of equity = no. of shares * price per share

This is also known as market capitalization.

DEBT

Technically there is a difference between the market value of debt

and book value of debt - but in most cases the two values will be

similar and hence we use book value as proxy for market value

Market value of debt will be the value at which debt is traded if

the bonds of the company are listed.

Dec-14

Deepak Kapur

21

EQUITY:

Intrinsic Value of Equity this is the estimate of the true worth of

equity of a business. This is what an analyst seeks to evaluate so

that he can compare the same with market value and decide on

buying or selling. Discounting free cash flows to equity at cost of

equity is the most fundamental method to get the intrinsic value of

equity

DEBT

Intrinsic value of Debt : This can be calculated as the present

value of all future interest and principal payments discounted as

the cost of debt of the firm.

Again: for well run firms where there is no distress in debt; the

intrinsic value of debt will be close to the book value of debt and

hence the latter is used for practical reasons.

Dec-14

Deepak Kapur

22

Always be careful of what is being valued

Value of company can mean either that of standalone or consolidated

company: & could refer to equity value or enterprise value [debt + equity]. It

could be the equity value or EV with or without non operating assets. The

person using this term value could be using could be referring to:

Intrinsic Value

Market Value

Book Value

Market Price

The terms market price and market value are interchangeably used we use the

term market value more when we talk of the value of the aggregate company and

use the term market price more when we talk of the price per share

Dec-14

Deepak Kapur

23

So

If someone asks you what is the value of company A, you

ask him/her which of the following value they are

referring to:

Book Value of Enterprise

Market Value of Equity

Market Value of Enterprise

Intrinsic Value of Equity

Intrinsic Value of Enterprise

Dec-14

Deepak Kapur

24

Can we compare profit margins across industries (NP margin /

Gross Profit Margin)?

Can we compare Return on Investment (RoE or RoIC) across

industries?

Dec-14

Deepak Kapur

25

Can we compare profit margins across industries (NP margin /

Gross Profit Margin)? No, comparison of profit margins is

useful for comparing companies within an industry and not across

Can we compare Return on Investment (RoE or RoIC) across

industries? yes. Since ultimately investors and entrepreneurs

chase return on investments, it makes sense to compare them

across industries. However investments need not necessarily go

into the industires with highest RoE. Both RoE as well as the

quantum of capital that can be deployed have to be studied.

Dec-14

Deepak Kapur

26

statements we are interested in the following

Where is the capital invested?

the balance sheet

The answer to the second question lies on the asset side

This asset side analysis in important in valuation

because this is what tells use whether the funds are

deployed in assets which are operating/core in nature

or non-operating/non-core in nature

Dec-14

Deepak Kapur

27

Capital or simple Return on Capital

Choose the correct answer:

RoIC = EBIT / (Debt + Equity)

RoIC = EBIDTA / (Debt + Equity)

RoIC = EBIT(1-t) / (Debt + Equity)

RoIC = EBIDTA (1-t) / (Debt + Equity)

Dec-14

Deepak Kapur

28

Capital or simple Return on Capital

RoIC = EBIT / (Debt + Equity)

RoIC = EBIDTA / (Debt + Equity)

RoIC = EBIT(1-t) / (Debt + Equity)

RoIC = EBIDTA (1-t) / (Debt + Equity)

Each of the above definitions used based on the purpose. However for standalone

calculation of Return on Capital, it is the third definition which is most often used.

The others are used more for comparative purposes. E.g. if two companies in the

same industry have different depreciation policies and operate in different tax

environments, it makes sense to use the second definition to compare their returns.

Always remember that the numerator and denominator have to be consistent

they should belong to the same group of stake holders

The earnings of the numerator should have been produced by the capital taken in

denominator

Return on Operating and Non Operating Earnings should be measured separately

This will also imply that cost of total capital should be compared to RoIC and cost of

equity to RoE and the two should not be mixed and matched

Dec-14

Deepak Kapur

29

Return on Equity

Choose the correct answer:

RoEt = PATt / Net Wortht

RoEt = PATt / Net Wortht-1

RoEt = PATt / Average Net Worth(t,t-1)

Dec-14

Deepak Kapur

30

Return on Equity

Choose the correct answer:

RoEt = PATt / Net Wortht-1

RoEt = PATt / Average Net Worth(t,t-1)

It Depends on the purpose but in absence of other information

it is the last definition which is most used. However there may

be instances where the second definition is most ideal e.g. a

company has done an IPO towards the year end and hence its

reserves and surplus as well as equity capital has shot up

because of this fund raising. In this instance, if we use average

net worth we would be underestimating the true RoE since this

new capital has not yet been put to use and hence the PAT does

not reflect returns from this capital.

Dec-14

Deepak Kapur

31

On the B/S

We study the asset side to separate the core and non-core

assets

We then analyze to see how the core and non-core assets are

financed

On the P/L

We want to make adjustments for:

Non recurring items

Separate out the core and non-core income, expenses and

taxes.

Also to reflect average normal income from the assets of the

company, we may adjust for capacity utilisation, business

cycle etc.

Dec-14

Deepak Kapur

32

2012?

What is networth in 2011 and

2012?

Dec-14

Deepak Kapur

33

Infosys RoE

From Database

Actual

Even though the above nos of RoE from a database seem to indicate that infosys RoE is

about 27% that is actually its blended RoE of operating and non operating income. In the

balance sheet of Infosys in year 2011 there was almost 16666 crore cash and

equivalents. Out of this total of cash and cash equivalents lets consider about 1666

crores as cash required for operation. So the balance 15,000 crore was excess cash.

Total Networth in 2011 was 25976 crores. So operating networth will be only about

10976 crores after subtracting excess cash. Also PAT of infosys for year 2012 was 8332

crores. Other income was 1904 crores (mostly interest income from excess cash) and

hence post tax other income would be just 1904*(1-0.3) or 1332 crores. Hence operating

PAT is (8332-1332) = 7000 crores. Hence true operating RoE on opening equity capital

is 7000/10976 or almost 63% !! Infosys has no debt so RoIc = RoE

Dec-14

Deepak Kapur

34

Infosys RoE

Dec-14

Deepak Kapur

35

Dec-14

Deepak Kapur

36

Reasons

Business cycle effects Sukhjit Starch, Jindal Poly etc.

To know how much to adjust study historic gross margins or average RoE

To know how long an abnormal period can last study industry demand and

competitive position; industry dynamics in terms of time required to set up new

capacities

One time income / expense

Should be eliminated

Capacity Utilization Effects

New capacities on stream so depreciation/ other expenses on books but capacities

not fully utilized and scale effects not fully reflected in current statements

Companies which raise fresh cash will have other income till the cash is deployed

Dec-14

Deepak Kapur

37

In 2011 2012 : worker unreast at one of its cooker factories and

pollution control issues at another: result was a fall in production.

Supply not enough to meet demand.

Hence FY 2012 PAT does not reflect normal level of PAT and is

underestimating normal PAT.

A quick way to adjust this would be apply average net margins of

last few years to the value of lost sales estimated and add this

figure to reported PAT.

Reported PAT: 30 crores

Sales lost: about 15% of previous year sales ( prev yr sales = 350

cr) = 52 cr.

Average Net Margins: 10%

Adjusted PAT = 30 + 0.1*52 = 35.2 cr.

Dec-14

Deepak Kapur

38

The reported PAT of a company is 500 mn. An analyst is trying to normalize

this PAT. The tax rate on ordinary profits is 50%. He notices that the P&L

statement had a one time income of 100 mn on which the tax rate was only 20%

and he has to adjust the reported PAT for this line item in order to calculate

normalized PAT. Apart from this all others items on the income statement were

normal in nature and need no further adjustment. What is the normalized

PAT of the company?

Dec-14

Deepak Kapur

39

Solution

The reported PAT of a company is 500 mn. An analyst is trying to normalize

this PAT. The tax rate on ordinary profits is 50%. He notices that the P&L

statement had a one time income of 100 mn on which the tax rate was only 20%

and he has to adjust the reported PAT for this line item in order to calculate

normalized PAT. Apart from this all others items on the income statement were

normal in nature and need no further adjustment. What is the normalized

PAT of the company?

Solution:

One time item to be excluded: 100 mn

Tax on this item: 100*0.2 = 20 mn

Normalised PAT = 500 80 = 420 mn

Dec-14

Deepak Kapur

40

Example

In 2006 Apollo Hospitals Ltd reported a PAT of 50 crores. As part of operating

expenses it showed an expenses of 15 crores on accreditation. In notes to

accounts it mentioned that such accreditation was valid for 3 years and the

company will look to renew it after 3 years. This is a tax deductible expense.

The marginal tax rate of AHL is 30%. What should be normalised PAT for

2006?

Dec-14

Deepak Kapur

41

Solution

In 2006 Apollo Hospitals Ltd reported a PAT of 50 crores. As part of operating

expenses it showed an expenses of 15 crores on accreditation. In notes to

accounts it mentioned that such accreditation was valid for 3 years and the

company will look to renew it after 3 years. This is a tax deductible expense.

The marginal tax rate of AHL is 30%. What should be normalised PAT for

2006?

Solution:

The 15 crores should be spread over 3 years and hence only 5 crores should

have been expense for this year.

Hence normalised PAT = 50 + 15*(1-0.3) 5*(1-0.3) = 57 crores or 14% higher

than reported

Dec-14

Deepak Kapur

42

models

For estimating Return on Equity (RoE) or Return on

Invested Capital (RoIC) always use the opening (or

previous years closing) Networth or Invested capital in the

denominator for the purpose of studying valuation models

in this course.

RoE 2012 = PAT 2012 / NW 2011

RoIC 2012 = EBIT(1-t) 2012 / IC 2011

Remember IC = Networth + Long Term Loans (including

Short Term Portion of Long Term Loans) + Short Term

Loans

Dec-14

Deepak Kapur

43

Dec-14

Deepak Kapur

44

Growth will depend on

Future opportunities

Amount retained out of earnings

Additional investments

The return generated on these investments

Part growth may be due to inflationary effects zero value growth

Part growth may be due better utilization of existing assets - not sustainable

he cannot forecast all three variable - growth rate, return on capital

and retained earnings independently. When any two are forecasted

the third is fixed as can be seen from formulae linking the 3 variables.

This kind of check should also be done after valuation is done.

We could measure the growth rate in net earnings, EPS or operating

profits.

Remember - Growth can create value only if RoC is greater than CoC

Dec-14

Deepak Kapur

45

Expected Long Term Growth in EPS If RoE remains constant

change in earnings = Reinvestment Rate * RoE

Divide both sides by current earnings

gEPS = b*RoE

RoE = PAT / BV of Equity

We can see from above formula that Growth rate cannot exceed

RoE since maximum retention ratio is one (assuming no external

capital brought in). Hence if a company wishes to grow at a rate

faster than its sustainable RoE it needs to keep raising and

investing capital in excess of its PAT i.e. raise new funds

Limitations of EPS growth formula

Focuses on per share number

Assumes reinvestments will generate returns at RoE

Dec-14

Deepak Kapur

46

If RoE expected to change and future RoE is RoEt+1 then:

Change in earnings (i.e EPS of next yr EPS of this year) = new

invst*RoEt+1 + existing invst*change in RoE

i.e. the additional EPS can come from two sources: 1.) the new

retained capital earning the RoEt+1 2) the old capital earning a

some additional (delta) RoE than it was earning before.

Divide both sides by current EPS

gEPS= b *RoEt+1 +[(RoEt+1 RoEt)/ RoEt]

The formula shows how small improvements in RoE can translate

into big growth

A company cannot sustain growth simply by improvements in RoE

So the higher the RoE today or more the competition lesser the likelihood of

improvement in RoE

Dec-14

Deepak Kapur

47

Growth in Net Income

Use real investments instead of retention ratio

Real investment for total firm = (change in net Long Term Assets + change in

WC) : Part of this is funded by equity holders and balance by debt

So, Reinvestment Rate for Net Income = [(net change in PPE + change in WC)

funded by equity holders / PAT]

In case of linear growth model where D/E remains stable : for every 100

invested in company 100*(1 - D/(D+E)) will be the amount equity holders have

to finance and the balance will be finance by debt holders.

If D/E ratio is 2:1 then if total reinvestment is 600 equity holders share will be

600* ( 1-2/3) = 200

Hence,

Equity Reinvestment Rate = [(Net Capex + Change in WC) (1 D/IC)] / Net

Income, where IC = D+E

gnet income = Equity reinvestment rate * RoE

Dec-14

Deepak Kapur

48

investment*change in RoE ( A )

Remember investment means equity investment or networth

since we are interested in growth of PAT

Divide both sides of (A ) by current PAT

Gnet income= equity reinvestment rate *RoEt+1 +[(RoEt+1 RoEt)/

RoEt]

Dec-14

Deepak Kapur

49

Stable RoC :

gNOPLAT = reinvestment rate*RoC

Reinvestment rate = [net change in LTA + change in WC]/NOPLAT

RoIC = NOPLAT / [Invested Capital]

Changing RoC :

gNOPLAT = reinvestment rate*RoNIC + [(RoNIC RoIC) / RoIC]

When the return on capital is changing, there will be a second component to

growth, positive if the return on capital is increasing and negative if the return

on capital is decreasing.

If the change is over multiple periods the second component should be spread

over each period

RONIC this is the new overall RoIC after new capital is invested

Dec-14

Deepak Kapur

50

Example

Data : Current year is 2012

RoE 2012 = 0.2

Change in Networth between 2011 and 2012 = 50

Company will maintain its reinvestment rate in future

can be maintained in future

Question 2: What is growth rate of PAT in 2013 and

2014 if RoE next year and beyond can be maintained at

30%

Dec-14

Deepak Kapur

51

Question 1

Question 1: What is growth rate of PAT in 2013 if RoE

can be maintained in future

Solution: Method 1 using formula

RoE 2012 = PAT 2012 / NW 2011 = 0.2; hence NW 2011 = 500

Since additional NW in 2012 is 50 the reinvestment rate is

50/100 = 50% or 0.5

Since this is a case of stable future RoE

expected growth rate in earnings = 0.5 * 0.2 = 10

NW 2012 = 500+50 = 550

Since RoE is 20%, PAT 2013 = 550*0.2 = 110

Hence growth in PAT = [(PAT2013 PAT 2012) / PAT 2012 ]* 100

= (110 100)/100 = 0.1 or 10%

Dec-14

Deepak Kapur

52

Question 2

Question 2: What is growth rate of PAT in 2013 and

2014 if RoE next year and beyond can be maintained at

30%

Solution method 1 using formula

Gnet income= equity reinvestment rate *RoEt+1 +[(RoEt+1 RoEt)/

RoEt]

reinvestment rate in 2012 = additional investment / PAT = 50/100

= 0.5 or 50% - data says this will also be same in future

Hence g 2013 = 0.5*0.3 + (0.3-0.2/0.2) = 0.15 + 0.5 = 0.65 or 65%

In 2014 the RoE will be same as was in 2013, hence g 2014 =

RoE*RR = 0.3*0.5 = 0.15 or 15%

Dec-14

Deepak Kapur

53

Question 2

Question 2: What is growth rate of PAT in 2013 and 2014 if RoE

next year and beyond can be maintained at 30%

Solution method 2 from basics

NW 2011 = PAT 2012 / RoE 2012 = 500

reinvestment rate in 2012 = additional investment / PAT = 50/100 = 0.5 or

50% - data says this will also be same in future

NW 2012 = NW 2011 + change in NW = 500 + 50 = 550

RoE 2013 = 30% - given: hence PAT 2013 = 0.3*550 = 165

g 2013 = (165 100)/100 = 65%

Reinvestment in 2013 = PAT 2013 * reinvestment rate = 165*0.5 = 82.5

NW 2013 = NW 2012 + 82.5 = 632.5

PAT 2104 = RoE 2014 * NW 2013 = 0.3 * 632.5 = 189.75

Hence g 2014 = (189.75-165)/165 = 0.15 or 15%

Dec-14

Deepak Kapur

54

1. Marginal Investors

2. Private Equity Investors

3. Buyers of Whole Businesses/New Management

Dec-14

Deepak Kapur

55

1. Marginal Investors

Diversify Their risk

No say in corporate action

Lesser Diversification of Risk

Part say in corporate action

Concentrated Risk

Complete Control

concentration of risk could mean higher discount rate and

hence lower value; more control would require to pay

higher

Dec-14

Deepak Kapur

56

especially in the context of listed securities?

Efficient Markets?

Rational Investors?

Inefficient Markets?

Irrational Investors?

Dec-14

Deepak Kapur

57

especially in the context of listed securities?

Efficient Markets?

Rational Investors?

Inefficient Markets?

Irrational Investors?

Markets are a mix and match of all of the above at ANY given

point in time the purpose of valuation is to figure out how

investors and markets SHOULD be pricing securities as

against what they ARE pricing them at

Dec-14

Deepak Kapur

58

Over time price of securities reflects the underlying intrinsic value

Dec-14

Deepak Kapur

59

The previous graph shows the 100+ years chart of the Dow Jones

Industrial average on the log scale.

The other lines on the charts are trends in Earnings per unit of

index, Dividends per unit of index and the Book Value per unit of

index

As we know earnings, dividends, book value are all indicators of

value of underlying asset

The chart clearly shows that over time as these indicators of value

increase the Price of the asset also shows an increase albeit in a

very volatile manner

The following slide shows a similar chart for the NSE Nifty index

in India over a 11 year period

Notice in both charts as price trend diverges from underlying

value trends, sooner or later there is reversion to mean

Dec-14

Deepak Kapur

60

Ja

n9

Ju 9

n9

No 9

v9

Ap 9

r- 0

Se 0

p0

Fe 0

b01

Ju

l-0

De 1

c0

M 1

ay

-0

O 2

ct

-0

M 2

ar

-0

Au 3

g0

Ja 3

n0

Ju 4

n0

No 4

v0

Ap 4

r- 0

Se 5

p0

Fe 5

b06

Ju

l-0

De 6

c0

M 6

ay

-0

O 7

ct

-0

M 7

ar

-0

Au 8

g0

Ja 8

n0

Ju 9

n0

No 9

v0

Ap 9

r- 1

Se 0

p1

Fe 0

b11

Ju

l-1

1

Value

800

700

Div Yield

Dec-14

index close

Deepak Kapur

Earnings

Book Balue

600

500

400

300

200

100

61

Sources of Value

And their link to the competitive

position of the firm

Dec-14

Deepak Kapur

62

Competitive Advantages

1.

2.

advantages are rare

Some sources of such an advantage are

Exclusivity by regulations / license

Sales based : customer loyalty

1.

2.

3.

High switching or searching costs products

Cost Based

1.

4. Economies of scale

1.

2.

Dec-14

reproducibility

Deepak Kapur

63

Marketing Prof

Q 2) What does Competitive Advantage mean?

Finance Prof

Asking the right questions, seeking the important

information, ability to overlook trivial data - are

very crucial to estimating fair value

Dec-14

Deepak Kapur

64

Marketing Prof

: I dont know

Q 2) What does Competitive Advantage mean?

Finance Prof

- It has to help the company earn a sustainable

return of capital in excess of its cost of capital

Dec-14

Deepak Kapur

65

Terminology

RCA

LV

EPV

Liquidation Value of Assets

Earning Power Value (without growth unless

otherwise mentioned)

EPVgrowth Earning Power Value with growth

r

Cost of Capital

RoIC

Returns on Invested Capital

IC

Invested Capital

g

growth rate

Dec-14

Deepak Kapur

66

Sources of Value

finding a value based upon the fact that intrinsic value can

come from:

1. Existing Value of the Assets of the company

2. The existing sustainable Earning Power of the company

3. Growing Earning Power from Profitable growth - returns above

its cost of additional capital

judge the competitive position of a company and its

sustainability

Dec-14

Deepak Kapur

67

Since assets of a company are in place, this is the most

certain of valuations for a company and is least corrupted

by forecasts.

Estimating the correct asset value requires a judgment of the

strategic situation of the firm

RULE ONE

For a Business in an Unviable Industry:

Asset Value = Liquidation Value

Asset Value = Reproduction Cost

Dec-14

Deepak Kapur

68

RULE TWO For Viable Firms

In a viable industry:

The Intrinsic Value of Firm is at least equal to reproduction cost of

assets if competitive advantages (CA) exist

The Intrinsic Value of Firm is just equal to reproduction cost of assets

if NO competitive advantages exist

WHY is the above statement true?

Dec-14

Deepak Kapur

69

RCA primarily represents the cost of the most efficient way

of reproducing the assets of the existing player

Includes investments required in recreating a sales and distribution set up

Includes the time value of money if starting from scratch

represent the amount a new entrant would need to invest in

the asset

Look at the liability side and estimate the spontaneous

liabilities the business generates. This effectively reduces

the investment required by new player

Calculate net asset value this is the reproduction cost

Dec-14

Deepak Kapur

70

Represent the best value a firm could fetch in a fire-sale or

staggered liquidation

Remember it will not be a going concern based value

Assets will fetch a value depending upon what best use they

can be put

Dec-14

Deepak Kapur

71

Earning power means sustainable distributable earnings that may

reasonably be expected over a period of time in the future (almost

equivalent to distributable cash flows)

Earning Power Value no Growth = Present Value of current

sustainable earnings (E) capitalized at an appropriate rate (r)

EPV = [E / r]

The Earnings to Consider are Normalized earnings: These reflect

average sustainable free cash flow numbers based on no growth capex

assumptions

This approach is uncontaminated by forecasts of future

Since we are assuming no growth and sustainable earnings r would

be close to or slightly above risk free rate

Dec-14

Deepak Kapur

72

Dec-14

its EPV, if competitive advantages exist (one can measure EPV

with growth also)

Deepak Kapur

73

1.

Management not using assets optimally; Industry operating with excess capacity

Chance to unlock value?

2. EPV = RCA

No competitive advantages; average management

Ignored growth but in a situation with no comp adv growth doesnt add value

because RoIC = r !!

Strong barriers to entry or sustainable competitive advantages or great management

(is great management a sustainable comp adv?)

[EPV RCA] = value of franchise

The defining character of a franchise is that it enables a firm to earn more than it

needs to pay for the investments that fund its assets

One has to make a judgment about the sustainability and source of this value

Dec-14

Deepak Kapur

74

The aim is to find normalised average sustainable FCFE from

existing assets, when there is no growth capex.

Start from Net Income and Adjust (on post tax basis) for

1.

2.

3.

4.

5.

Business Cycle adjustments

Capacity utilization adjustments

Maintenance capex adjustment

Leverage Adjustments ( is D/E too high or low than would in stable state?

If yes, then a) interest cost would accordingly have to be adjusted and b)

some cash kept aside to pay off excess debt over time this has the affect

of reducing FCFE OR some cash will come in from raising more debt over

time and this has the affect of increasing FCFE

reported post tax EBIT for the above. (Leverage adjustments will

not

feature at Enterprise Level

valuation)

Dec-14

Deepak Kapur

75

put a value to growth separately in order not to corrupt other estimates

based on bird in hand value.

growth on a level economic playing field adds no value need moats

Growth requires new investments - Can Growth Come Without

Additional Investments?

Does Growth bring increase in value?

If RoIC = r : growth produces no value

If RoIC < r : growth will destroy value

If RoIC > r : growth will create value

sustainable competitive advantage leading to superior returns

This occurs when EPV >> RCA

Dec-14

Deepak Kapur

76

Balanced Growth

a change in revenues will imply a proportional change in profit

Assets and liabilities required to support this growth will also

grow proportionally

Implies capital required to support this growth grows

proportionally

growth DCF formula re-written in terms of these variables)

RoIC = r => EPVgrowth = IC

RoIC < r => EPVgrowth <IC

RoIC > r => EPVgrowth >IC

Dec-14

Deepak Kapur

77

Growth Multiplier

M = EPVgrowth / EPV

= [1 (g/r)(r/RoIC)] / [1- (g/r)]

The higher the (g / r) and lower the (r / RoIC) greater the value of

growth

R/r

g/r

Dec-14

1.5

2.5

0.25

1.11

1.17

1.2

1.22

0.5

1.33

1.5

1.6

1.67

0.75

2.5

2.8

Deepak Kapur

78

Discrepancies between RCA and

EPV represent both an

opportunity and caution

EPV

Franchise

Value from

current

competitive

advantage

adv sustain?

Value of

Growth only

if growth

within

franchise

Asset value

Reproduction

Cost

Free entry

No comp adv

Dec-14

Deepak Kapur

79

2+8=10

4+6=10

6=10-4

Dec-14

Deepak Kapur

80

Value

Enterprise DCF

use free cash flows to firm (FCFF)

These are cash flows prior to debt payments but after meeting all

reinvestment needs for growth assets

The discount rate will reflect the cost of raising both debt and equity capital

in proportion to their use (Weighted Average Cost of Capital (WACC))

Equity DCF

Use free cash flows to Equity holders (FCFE)

These are cash flows from assets after debt payments and after meeting reinvestment needs

The discount rate would reflect the cost of equity (CoE)

Various data bases and books differ in the way they define Free

Cash Flows the essence rather than technical definition is

important

Dec-14

Deepak Kapur

81

Invested Capital (IC)

NW + Long term Debt + Short Term

Debt

Operating Profit

Operating Revenues Cost of

Revenues = EBIT

NOPLAT

Operating profit less operating taxes

(NOPLAT = EBIT(1-t) ), where t is the

operating tax rate i.e. tax rate of a

completely equity financed firm

ROICt

NOPLATt/ICt-1

Investment Rate (IR)

Net Investment /NOPLAT

Net Investment

ICt+1 ICt (if measured from liability

side) or Change in Net long term assets

+ change in working capital (if

measured from asset side)

Growth in NOPLAT

g = ROIC*IR (when RoIC is stable)

Free Cash Flow Firm (FCFF) NOPLAT Net Investment

Dec-14

Deepak Kapur

82

Networth (NW)

Surplus

Net Profit

PAT

RoEt

PATt/NWt-1

Reinvestment Rate (RR) Retained earnings / PAT

Net Equity Investment NWt+1 NWt = Retained earnings

Growth in PAT

g = RoE*RR (if RoE is stable)

Free Cash Flow (FCFE) PAT Net Equity Investment Net

Debt Repaid

Dec-14

Deepak Kapur

83

to learn valuation modeling

a change in revenues will imply a proportional change in profit

Assets and liabilities required to support this growth will also grow

proportionally

Such an assumption makes it easy to study and apply valuation models

So if analyst projects profits to grow 10% then he will also project out capital

to grow 10% if RoC is expected to remain same

assumes linear growth model!!

Since FCF is EBIT(1-t) reinvestment in capex and WC

WE can re-write equation (A) as

V = [Capitalt=0 *(RoCt+1 g)] / (CoCt+1 g)

Where Captial = Networth or Invested Capital depending on whether V

is value of equity or enterprise; similarly CoC will be either CoE or

WACC and RoC will be either RoE or RoIC

Dec-14

Deepak Kapur

84

For a Company with constant rate of growth of Free Cash Flow(FCF)

The formula below is also known as the value driver relationship,

because it shows the links between the various value drivers and the

value of future cash flows

Value

FCFt 1

(this is the PV formula for growing perpetuity whereFCF t 1 FCFt * (1 g) )

WACC g

NOPLATt 1 * (1 IR)

WACC g

g

)

RONIC

WACC g

This can be rewritten as ICt*(RONIC-g) / ( WACC-g),

where RONIC is the ROIC expected for next year

NOPLATt 1 * (1

Dec-14

Deepak Kapur

85

Value

Dec-14

FCFt 1

WACC g

NOPLATt 1 * (1 IR)

WACC g

NOPLATt 1 * (1

WACC g

g

)

ROIC

g

)

ROIC IC ROIC g

0

WACC g

WACC g

IC0 (ROIC) * (1

IC0

WACC g

IC0

ROIC WACC

IC0

WACC g

Deepak Kapur

86

Free Cash Flow to Firm or FCFF

FCFF = NOPLAT + Dep Capex Change in WC >(A)

Capex = Change in Net Long Term Assets + Depreciation >(B)

Change in WC = WC of current year WC of previous year

Using (B) the expression ( A ) can be simplified to

FCFF = NOPLAT Change in Net LTA Change in WC

I) FCFE = FCFF Net debt repaid post tax interest payment

Net debt repaid = (opening debt closing debt)

Post tax interest payment = interest*(1-t)

II) FCFE = PAT + Dep Capex Change in WC Net Debt repaid > (C)

Using ( B ) expression ( C ) becomes

FCFE = PAT Change in Net LTA Change in WC Net Debt Repaid

Dec-14

Deepak Kapur

87

For debt free company

FCFE = PAT + Dep (Change in net long term assets +

Depreciation) Change in WC

FCFE = PAT (change in net long term assets + change in

WC)

assumptions, any change in net worth will total the

change in net long term assets and working capital

Hence FCFE = PAT Change in networth

Dec-14

Deepak Kapur

88

2. Calculate FCFE for year 2011.

Dec-14

Deepak Kapur

89

Calculations

NOPLAT2011 = (PBT+I)*(1tax rate) = (20100(*0.7) = 14070

Depreciation for year = 6500

Change in Net LTA = 82500 77000 = 5500

Change in WC = 20300 15800 = 4500

FCFF = 14070+6500 (5500 + 6500) - 4500 =4070

FCFE = FCFF net debt repaid post tax int payment = FCFF net debt repaid post tax int payment = 4070 - ( 55000 - 60000)

4500*0.7 = 5920

paid = 10920 + 6500 (5500 + 6500) 4500 (-5000) = 5920

Dec-14

Deepak Kapur

90

Terminology

Economic

Profit

over the cost of capital. Similar to EVA for firm.

Residual

Earnings

The excess earned on the Book Value over the Cost of

Equity. Similar to EVA for Equity.

Residual Earningst = BVt-1*(RoE-CoE)

Dec-14

Deepak Kapur

91

1. Calculate Economic Profit (EP) for year 2011. WACC = 10%, t=30%

2. Calculate Residual Earnings (RE) for year 2011. CoE = 12%,

Dec-14

Deepak Kapur

92

Solution process

Step 1 calculate NOPLAT

Step 2 calculate RoIC and RoE

Step 3 calculate Economic Profit and Residual

Earnings

Dec-14

Deepak Kapur

93

Solution

EBIT 2011 (PBT+ interest)

20100

NOPLAT 2011

14070

IC 2010

92800

WACC

0.1

0.151616

PAT 2011

10920

Networth 2010

37800

CoE

0.12

0.288889

Dec-14

4790

Deepak Kapur

6384

94

Levered CoE Cost of equity for a company as usually

calculated . If the company has debt, the risk and

benefits of debt will reflect in the CoE.

Unlevered CoE The cost of equity for a company

adjusted for risk and benefits of leverage. In other

words unlevered cost of equity is the cost of equity for a

company HAD it been totally equity financed.

Dec-14

Deepak Kapur

95

Model

What is

Valued

Discount

Rate

Basis

What to

Discount

Enterprise DCF

(FCFFM)

Operating CFs

Equity DCF

(FCFEM)

Equity

Cash Flows

CFs to Equity

Economic Profit

(EPM)

Accrual Accounting

Economic Profit

Residual Earnings

(REM)

Equity

Levered

CoE

Accrual Accounting

Residual

Earnings

Dividend Discount

(DDM)

Equity

Levered

CoE

Cash Flows

Dividends

Adjusted Present

Value (APVM)

CoE

Cash Flows

Operating CFs

Dec-14

Levered

CoE

Deepak Kapur

96

FCFF

t n

FCFFt

FirmValue

t

t 1 (1 WACC )

t n

FCFE

FCFE t

Equity Value

t

(

1

CoE

)

t 1

t n

DDM

APV (MM

Theorem)

Div t

EquityValue

t

(

1

CoE

)

t 1

APV = PV of FCFF + PV of tax shields PV of bankruptcy cost =

FCFF (for FCFF use unlevered CoE as discount rate / for tax shields

its cost of debt or unlevered CoE)

All Models (other than DDM) will give the same value. Equivalence will hold IFF you make

consistent

assumptions

Dec-14

Deepak

Kapur

97

Interest is a genuine business expense and is hence tax deductible.

This means that tax is calculated only after deducting interest

from operating profits. So if an equity financed firm has PBIT of

100 and tax rate is 30% it pays 30 as tax since its PBT = PBIT. If

the same firm had debt and interest was 20 then PBT would 80

and tax would be 24. hence tax savings due to interest = 6 which

nothing but tax rate* interest = 20*0.3 = 6. This is also known as

interest tax shield. Since it reduces tax outgo its increasing cash

flows and hence adds value.

Enterprise DCF and APV give the same value but only differ in

the way they calculate the PV of interest tax shields

Where in Enterprise DCF are we accounting for the interest tax

shield?

In the WACC remember we use post tax cost of debt

Dec-14

Deepak Kapur

98

Discounted

Economic

Profit Value

IC t ( ROIC t 1 WACC t 1 )

FirmValue IC 0

t 1

(

1

WACC

)

t 0

Residual

Earnings

Model

EquityValue BV0

t 1

(

1

CoE

)

t 0

t n

t n

Accrual Accounting Models Should give same value at Cash Flow models if assumptions are

consistent

Dec-14

Deepak Kapur

99

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