1

Beauty lies in the eyes of the

beholder; valuation in those of the
buyer

2
 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 owner’s 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.
3
 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
4
 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
5
• 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

6
 Key Valuation tools
 Present value of projected unlevered free cash flow
Discounted Cash Flow
 Captures the “intrinsic value” of the business

 Based on market trading multiples of comparable comp

Relative Valuation
 Usually focuses on forward looking Profit / EBITDA / Cash Flow

 Based on multiple paid for comparable comp. assets in sale transaction

M&A Comparables
 Focus mainly on multiples of Historical Profit / EBITDA / Cash Flow

 Based on fair value of individual assets

Asset Valuation
 Book Value may not be equal to fair value

 Divides the business into separate sub-entities (parts)

Sum of Parts
 Add the value of each part to find the total value

7
 Principles of Valuation
• Book Value
– 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)

8
 Synergy
• 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.
•
9
 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
10
 Cost of acquisitions
• Payment to equity share holders (No. of equity
shares x MP of equity share)
• + payment of preference shareholders
• + 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.
11
 Approaches to valuation

Market approach Asset approach.

Income approach

Capitalization method Comparable company method Adjusted Book Value method

DCF method

12
 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.

13
 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
425
C a s h F lo ws (R s m n)
400

300
Terminal Value

200
102 110
89
100 53
24 24 31
17

0
2008 2009 2010 2011 2012 2013 2014 2015 2016

Annua l c a s hflo w Te rm ina l Va lue

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. 16
 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

17
 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 =
18
 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

19
 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
20
 Cash flow & discount rates
Year CF to Equity Interest expense CF to firm
In $ in $

1 50 40 90

2 60 40 100

3 68 40 108

4 76.20 40 116.20
5 83.49 40 123.49

6 Terminal 1603.0 2363.008

value

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 22
 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.

23
 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.
24
 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 price-
to-cash-flow-per-share ratio or price-to-
book-value ratio, Beta factor etc 25
 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, enterprise-
value-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.

26
 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 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 multiple.
28
 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.

29
 Value of firm – comparable firm approach

Company A Company B Company C

EV/Sales 1.4 1.1 1.1

MV/EBDITA 17.0 15.0 19.0

MV/FCF 20 26 26

30
 Value of firm – comparable firm approach

• Valuation A B C average

multiples of
comparabl
EV /sales 1.4 1.1 1.1 1.2
e firms

MV/EBDITA 17.0 15.0 19.0 17.0

MV/FCF 20 26 26 24.0

31
 Value of firm – comparable firm approach
• Value of ABC ABC co Average value
based on
comparable sales 200 1.2 240
multiples
• Weightage to MV/EBDITA 14 17.0 238
P/S,P/E,P/BV
1,2&1. MV/FCF 10 24.0 240

32
 Value of firm – comparable firm approach
• Weighted average will be
• { 240x1) + (238 x2) + (240x1)}/4 = Re 318 cr
• Value of ABC = Re318cr.

33
 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.

34
 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.
35
 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)

36
 Cash flow to Firm model
EBIT Re 500 lacs.
Expected to grow at 5 % for
5 years
Capital expenditure Re 300 Lacs

Depreciation Re 200 lacs

Revenue Re 7000 lacs

Expected to grow at 5 % for
5 years
WC as % of revenue 25%

Tax rate 36%

Capital expenditure are off
set by depreciation 37
 Free cash flow to the firm = EBIT(1-t)+depreciation and amortization
– capital expenditure – change in working capital

0 1 2 3 4 5

EBIT 500 525 550 580 610 640

- taxes 180 189 198 210 220 230

- capex 100 105 110 115 120 126

- 90 90 95 105 100
Change
in WC
FCFF 220 141 152 160 165 18438
 Estimation of change in working capital

Revenues 7000 7350 7720 8100 8510 8930

Working 1750 1840 1930 2025 2130 2230

capital

Change in 90 90 95 105 100

WC

39
 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).
40
Yr FCFF Debt Int.(1-t) Principal FCFE
repaid
0 (12,00,000) 4,00,000 (8,00,000)
Equity 8 +
debt 4)
1 80,000 20,480 59520
2 1,04,000 20480 83520
3 1,35,200 20,480 1,14,720
4 1,75,760 20,480 1,55,280
5 3,07,580 20,480 2,87,100
6 5,38,265 20,480 4,00,000 1,17,785
41
 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.

42
 Where Does the Discount
Rate (k) Come From?
• CAPM: k = rf + xRP
• Beta () 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
43
 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
44
 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

45
 Cost of equity
• Cost of equity is the expected return by
investors. There 2 methods
• CAPM
• Arbitrage Pricing Model.

46
 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.

47
 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
48
 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

49
 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.
50
 CAPM
• 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
company’s beta factor is that company’s 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.
51
 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.
52
 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
two. 53
 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.
54
 Security market line

β1
C
β>1
B
BB
C

AA A BB
AA
β<1

55
 Security market line
Rate of
return
C
17.5
BB
15.0
AA
12.5

Rf=10

05 1.0 1.5 2.0

Beta 56
 Capital Asset Pricing Model
(CAPM)
• Ks = Krf +β (Km – Krf)
• Ks – required rate of return
• Krf = Risk free rate (rate of return on risk
free investment. E.g. GOVT.securities
• β = beta
• Km – expected return on the over all stock
market

57
 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
58
 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 + β ( 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.

59
 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.

60
 Beta versus risk premium

• XYZ co is a private Firm Beta D/E

operating in textile
industry. D/E- 0.2.Tax A 1.10 0.24
rate @ 36%. Estimate
the Beta if D/E goes up B 1.22 0.33
to 0.23.
• Information on other C 1.35 0.22
firms in textile industry
d 1.20 0.20

61
 Beta versus risk premium
• βL = βU [ 1+ (1-t) (D/E) ]
• βL = levered beta for the equity firm.
• βU = unlevered beta of the firm
• t = corporate tax rate
• D/E = debt/equity ratio
• Average β 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
• Β for XYZ Co
• = 1.05 [1+(1 -0.36) (0.23)]
• = 1.05 x 1.15
• = 1.21 approximately.

62
 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-à-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 ] β1 +[E(F2) – Rf ] + …… +[E
(Fk) - Rf] βk
• E(F1) = Expected rate of return on a portfolio that resembles the
kth factor independent of all other factors.
• Βk = sensitivity of the stock return to the kth factor.

63
 Arbitrage Pricing Model (APM)

• T- bill trades @ 4.5%. Factor 1 Factor 2 Factor 3

Assume 3 different
factors are
considered.
Risk 4% 4.5% 3%
• Estimate the cost of premium
equity

Beta 1.25 0.95 1.15

64
 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%

65
 Terminal value or continuing value
• A company’s 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 = + terminal value
------------------
( 1 + kc )^n

66
 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.
67
 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.
68
Year Cash Disc.@ Present
flow 15% value
1 (10) 1.15 (8.69)
2 5 1.323 3.779
3 10 1.521 6.575
4 15 1.749 8.576
5 20 2.011 9.945

NPV 28.875 69
 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.
70
 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

71
 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

72
 Two stage dividend discount model
• Vo = + Vn / (1 + Ke,s)^ n

73
 Value of equity in 2 stage discount model

• XYZ ltd is a Particulars High Stable

manufacturer of growth growth
electronic goods.
Reported EPS in period
March,2005 Re 5.7
Length of the 4 years Perpetual
and dividend @ Re
2.28. period after 4 yrs
• Tax rate@ Exp. Growth. ? 8%
40%.T.bill rate@ rate.
7%.Market premium
5% Beta 1.3 1.15
• Estimate value of Ret. on. assets 15% 15%
equity using
dividend discount D/E 1 1
model DPS 40% ?
74
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

75
 Value of equity in 2 stage discount model- Estimation of value of equity

Year EPS DPS Disc.rate@13.5% PV

1 2 3 4 5(3/4)

1 6.56 2.6424 1.135 2.311

2 7.55 3.070 1.288 2.344

3 8.69 3.477 1.462 2.378

4 10.00 4.003 1.659 2.411

•Ks = Krf +β (Km – Krf)

•High growth rate = 7%+1.3(5%) = 13.5%
•Stable growth rate = 7% +1.15(5%) = 12.75% 76
 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 firm’s 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%
• β = 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 2006 2007 2008 2009 Termin

al value
1314 1438.83 1575.52 1725.19 1889.09 1964.65
EBIT
- Tax@40% 525.6 575.53 630.21 690.07 755.64 785.86

- (Capex) 76.65 83.93 91.91 100.64 110.20 114.61

-(Ch. in .WC) 123.5 135.23 148.08 162.15 177.55 81.86

588.25 644.14 705.32 772.33 845.7 982.32

FCFF
PV of 538.69 540.16 541.64 543.13 544.21
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 Amount Assets amount

• Hypothetical (Re in lac)
ltd ( H)
Equity ( 4 lac 400 Cash 10
wants to shares of Re
acquire 100 each
Target ltd Reserves 100 Debtors 65
(T). Balance
sheet of T
11% Deb. 200 Stock 135
ltd

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.
Year end Re
Shares of H is valued at MP of
Re180 per share. 1 150
• Debentures holders will get 11%
for the same amount
2 200
• External liabilities are expected
to be settled at Re 150 lacs.
• Dissolution expenses @ 15 3 260
lacs. To be met by acquiring
company. projected FCFF for 6 4 300
years.

5 220

6 120
86
 APV method
• FCFF of T is expected to Equity Re 540
grow @ 3% after 6 years (3,00,000 x
180)
• Cost of capital @ 16%
11% 200
• Unrecorded liability Re 20 debentures
lacs
External 150
• Advise the company liabilities
regarding financial
feasibility of acquisition. Un recorded 20
liability
• Cost of acquisition
Dis.Exp. 15
• if FCFF is likely to grow
• TV6 = FCFFt (1+g)/(Ku- g)
• If FCFF is likely to decline Total 925
• FCFFt (1+g)/(Ku +g) 87
 APV method
Yr end FCFF PV@ Total
• Terminal value 16% PV
• TV6= FCFF6(1+g)/ 1 150 0.862 129.30
( Ku – Kg)
2 200 0.743 148.60
• = Re 120 lac (1.03) /
(0.16 – 0.03) = 3 260 0.641 166.66
Re 950.77 lac 4 300 0.552 165.60
• PV of TV =
5 220 0.476 104.72
• 950.77 x 0.410 =
Re 389.82 lac 6 120 0.410 49.20

•
Total 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 = 764.08
• 2. PV of TV = 389.82
• 3. PV of tax shield = 70.00
• Total APV = 1223.90
• Less cost of acquisition = 925.00
• NPV = 298.90
• Acquisition is viable. 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

11% debentures 200

External liabilities 150
Un recorded liability 20
Dis.Exp. 15

Total 925
91
 Continuing value
Year end FCFF PV@13 Total PV in
Re
1 150 0.885 132.75

2 200 0.783 156.60

3 260 0693 180.18

4 300 0.613 183.90

5 220 0.543 119.46

6 120 0.480 67.60

Total 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 2 3 4 5 TV

EBIT 2.40 2.88 3.46 4.15 4.98 5.23

-EBIT –Tax 1.56 1.872 2.249 2.6975 3.237 3.3995

- Capex – depre 0.60 0.72 0.86 1.04 1.24 0.00

FCFF 0.96 1.152 1.389 1.6575 1.997 3.3995

Terminal Value *52.06

*
3.3395/0.1153-
0.05= 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 0.75 0.94 1.17 1.46 1.83 1.98

Less (capex 0.45 0.54 0.65 0.78 0.93 0.00

– depre)
X(1-D/E)
FCFE 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 multiple.

102
 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