Lecture 1

24th August, 2009

By
Shobhit Aggarwal
Introduction to Valuation
Why value companies ?

 Price is what you pay

 Value is what you get
 The basic purpose of valuation is to find
the right price to be paid/received
 The purpose is not just to evaluate the
value of an asset but also the source of
this value
Why value companies ?

 Every asset has a value

 Although the techniques may differ but the
basic principles remain the same
 Common sense says that you should not
pay more for an asset than it is worth
 But “Bigger fool theory” prevails
Disagreements in valuation

 What is the fair value for an asset?

 How much time will market price take
to adjust to fair value?
Perspectives in Valuation

 Share purchase/sell
 Mergers and acquisitions

 Private placements

 Sell-offs

 IPOs/Secondary Offerings

 Rights issues
Biases in equity research
 Strong buy bias
 Information
 Fund managers

 IB divisions

 Stay with the pack

Myths associated with valuation
 Myth 1: Valuation is objective as the
valuation methods are quantitative
 The biases and the purposes vary
 Do not take decisions before valuation is

complete
Myths associated with valuation
 Myth 2: A well-researched and well-done
valuation is timeless
 New information changes value
 Info could be firm-specific – business model
 Info could be sector specific – government

regulations
 Info could be economy wide - recession
Myths associated with valuation
 Myth 3: A good valuation is a precise
estimate of value
 Accuracy of assumptions made in a valuation
dictate the final accuracy of the valuation
 The business life-cycle, the economic
situation, the country/countries of operation,
the number of separate business lines all add
to uncertainties in the assumptions
 The benefits to valuation are greatest where
difficulties are more
Myths associated with valuation
 Myth 4: The more quantitative a model,
the better the valuation
 As models become more complex, they need
more inputs – hence more prone to errors
 In fact, more complex models become difficult

when the analyst who made them is no longer

there
Myths associated with valuation
 Myth 5: To make money using valuation,
you have to assume that markets are
inefficient
 Markets are efficient because people are
continuously trying to find stocks that are
under-valued or over-valued
 Implicit is the assumption that markets will

correct after you take positions

Myths associated with valuation
 Myth 6: The value you find is important,
the process to arrive at it is not
 The process of valuation can tell us the weak
points and the sources of value. This allows
us to see :-
 How sustainable is the value we found?
 What to change to improve valuations?
Role of valuation
 Fundamental analysts
 The investment rationale is valuation
 Technical analysts
 To develop support and resistance levels
 Information traders
 For the relationship between information and value
 Market timers
 Evaluating whether market is under-valued or over-
valued
 Efficient marketers
 To find out the implicit assumptions of growth and
risk in the market
Role of valuation – Investments
 Fundamental analysts
 The investment rationale is valuation
 Technical analysts
 To develop support and resistance levels
 Information traders
 For the relationship between information and value
 Market timers
 Evaluating whether market is under-valued or over-
valued
 Efficient marketers
 To find out the implicit assumptions of growth and
risk in the market
Role of valuation – Acquisitions
 Value from acquirer’s perspective
 Value from target’s perspective

 Value of synergy

 Value of changing management

 Value of restructuring
Concept Checker
 Value of an asset depends on the demand
and supply in the market
 Value is determined by investor

perceptions about the asset

 Value of an asset depends on the

methodology or the model used

 Value of an asset will depend upon the

assumptions used in a model

Approaches to valuation
 Discounted cash flow
 The value of an asset is the present value of
its future expected cash flows
 Relative valuation
 The value of an asset is estimated using
pricing of comparable assets
 Contingent claim valuation
 Option pricing methods to value assets
having option like characteristics
Relative Valuation
 Law of one price
 Similar assets should trade at the same price in the
market
 Comparison to other peers (Cross-sectional
analysis)
 Assumption that all firms except the one under
valuation are fairly valued
 Comparison to past ratios (Time series
analysis)
 Assumes that fundamentals have not changes and
that the company was fairly valued in the past
DCF
 DCF tries to estimate intrinsic value of an
asset
 Intrinsic value is the value that an all-knowing
analyst will estimate
 Three paths to DCF valuation
 Value equity (DDM, FCFE, Residual Value,
VC)
 Value the firm as a whole (FCFF)

 Valuation in parts (APV)

When DCF runs into trouble
 Sick firms
 Cyclical firms

 Firms with unutilized (or underutilized)

assets
 Firms with patents

 Firms undergoing restructuring

 Firms involved in acquisitions

 Private firms
Pitfalls in relative valuation and DCF
 Relative valuation
 Analyst chooses the comparables and does
can justify his biases
 The under/over-valuation of a market as a

whole is overlooked
 DCF
 The analyst makes the assumptions about
cash flows, risk and growth and can thus
justify his biases
Valuation Methodologies - Summary
 Relative Valuation
 DCF
 Valuing equity
 Dividend Discount Model

 FCFE

 Residual Value

 Venture Capital Method

 Valuing firm
 FCFF

 Valuation in parts
 APV

 Real Options
Reading Financial Statements
Principal components of Balance Sheet
 Assets
 Economic resources that are likely to produce future
economic benefits are can be measured with a
reasonable degree of certainty
 Liabilities
 Economic obligations that are likely to produce
future economic costs and can be measured with a
reasonable degree of certainty
 Equity
 The difference between Assets and Liabilities
Sample Balance Sheet
 Current assets
 Cash and cash equivalents 500
 Accounts receivable 1200
 Inventory 800
 Long term assets
 Property Plant and Equipment 1700
 Total assets 4200
Sample Balance Sheet
 Current liabilities
 Accounts payable 600
 Short-term debt 1000
 Current portion of long-term debt 200
 Long term liabilities
 Long term debt 1500
 Total liabilities 3300
 Share Capital 100
 Retained Earnings 800
 Total equity 900
 Total liabilities and equity 4200
Principal components of Income Statement
 Revenues
 Economic resources generated in a particular
time period. Revenues should be recognized
when
 The firm has provided all or almost all goods
and/or services to the customer
 The customer has paid cash or is expected to

pay cash with a reasonable degree of certainty

Principal components of Income Statement
 Expenses
 Economic resources used up in a time period.
Expenses are recognized by matching and prudence
principles. They should be recognized when
 They are costs directly associated with revenues
recognized in the same period
 They are costs associated with benefits that are
consumed in this time period
 They are resources whose future benefits are not
reasonably certain
 Profits
 They are the difference between revenues and
expenses
Sample Income statement
 Revenues 1900
 Cost of goods sold (700)
 Gross profit 1200
 Selling, general and admin expenses (300)
 Other expenses (150)
 EBITDA 750
 Depreciation and amortization (150)
 EBIT 600
 Interest (100)
 Earnings before Tax 500
 Tax (150)
 Net Income 350
Sample Cash Flow Statement
 Cash Flow from operations 500
 Investing Cash Flow (300)
 Financing Cash Flow 100
 Net change in cash 300
 Opening cash 200
 Closing cash 500
Accounting Analysis
What is accounting analysis?
 Accounting analysis is the process which
evaluates the degree to which a company’s
accounting captures its economic reality
 Accounting flexibility and management
discretion together cause the accounting
numbers to be different from underlying
economics
 The analyst has to know how to restate the
accounting numbers to undo the effects of
accounting distortions and bring them closer to
economic realities
What makes accounting data unreliable?
 Rigidity of accounting rules
 E.g. All R&D must be expensed in some
countries
 Random forecast errors
 E.g. credit defaults
 Management discretion
Why would management distort numbers?
 Debt covenants
 Management compensation
 Tax considerations
 Corporate control
 Regulatory considerations
 E.g. anti-trust, import tariff, quotas
 Capital market considerations
 Stakeholder considerations
 E.g. labor unions
 Competitive considerations
Doing Accounting analysis
 Step 1: Identify key accounting policies
 E.g. forecasts of credit card defaults,
forecasts of residual values in leasing
business
 Step 2: Assess accounting flexibility
 Does the firm have flexibility in its key
success factors?
 E.g. Default rates in banking, R&D in bio-tech
firms
Doing Accounting analysis
 Step 3: Evaluate Accounting Strategy
 Compare policies to peers
 E.g. Is a lower default rate due to better risk controls or
aggressive assumptions?
 Are the incentives to distort reality strong?
 Has the company changed any policy? What is the
justification? What is the impact?
 Has the company’s policies been realistic in the past?
 E.g. Huge write-offs on goodwill, last quarter adjustments
 Are some business transactions inspired from accounting
benefits?
 E.g. Leases
Doing Accounting analysis
 Step 4: Evaluate the quality of disclosure
 Does the company give enough disclosures to assess
the firm’s strategy?
 Do the footnotes explain the accounting policies and their
logic?
 E.g. differences in revenue policies
 Does the firm adequately explain its current
performance?
 E.g. profit margins going down is visible in statements but is it
because of cost pressures or competition?
 If accounting policies restrict freedom, does the M,D&A
give pointers to the effects?
 E.g. Training expenses that were not allowed to be included as
assets
Doing Accounting analysis
 Step 4: Evaluate the quality of disclosure
 What is the quality of segment disclosure?
 E.g. Does it give only revenue break-up or only
net profit break-up.
 E.g. Are there significant inter-segment effects?

 Is the management forthcoming with bad

news?
 Does it give reasons for poor performance?
 How strong is the investor relations program?
 Is the management accessible to analysts?
Doing Accounting analysis
 Step 5: Identify potential red flags
 Unexplained changes in accounting policies,
especially when performance is poor
 Unexplained transactions that boost profits
 Unusual increases in account receivables compared
to sales
 Relaxing credit policies or hastening this year’s

sales by loading distribution channels

 Unusual increases in inventory compared to sales
 Is the inventory build-up for finished goods, WIP or

raw materials?
Doing Accounting analysis
 Step 5: Identify potential red flags
 Is the gap between net income and cash flow from
operations increasing?
 Is the gap between its reported income and tax
income increasing?
 Does the company use financing mechanisms like
sale of AR with recourse?
 Unexpected large asset write-offs
 Large fourth quarter adjustments
 Qualified audit opinions or changes in auditors
 Related party transactions
Doing Accounting analysis
 Step 6: Undo accounting distortions
 The cash flow statement and the financial
statement footnotes can help the analyst in
removing the effects of accounting distortions
Accounting analysis pitfalls
 Conservative accounting is not necessary good
accounting from an analyst’s perspective
 Income smoothing can be a reason for conservative
accounting
 Do not confuse unusual accounting with
questionable accounting
 Different strategies may require different accounting
 Not all changes in accounting policies are
earning management
Thank You