IIM Calcutta

Valuation Crasher
Valuation & Its Importance
Why do we value assets/firms?
• Valuation may be done for several reasons, and depending upon the objective, different numbers can be arrived at
for the same entity
• Not because different methods are inconsistent with each other, but because different methods value something
different!
• Different purposes require different valuation metrics
• Assets and/or firms are valued for a variety of reasons, some of which have been described below

• Various kinds of market • Banks/NBFCs employ several • Companies planning to publicly

investors (mutual funds, valuation techniques in order to list their stock (i.e., via an Initial
common investors, etc.) who assess the quality of the Public Offering) hire Investment
are looking to earn money from collateral they receive for Banks in order to value their
investing in equity markets providing a loan business that helps determine
• Such investors rely majorly on • The cost at which a company the listing price
publicly available information to can borrow/raise money also • Companies engaging in M&A
perform valuation depends on its value deals use valuation to
determine terms & conditions
of the deal
IPOs, Mergers
Market Lending /
and
Investing Financing
Acquisitions 2
Types of Valuation Methods
How do we value assets/firms?
Discounted Cash Flow (DCF) Methods
• Primary Rationale – the maximum price one should be willing to pay for an asset should not be more than
the present value of future expected cash flows one expects to receive
• Different Methods – Dividend Discount Model, Free Cash to Firm (FCFF) based Model, Free Cash to Equity
(FCFE) based Model
• Each of the method described above has its pros and cons, and involves a different set of parameters
• Pros- Technically rigorous, allows for sensitivity analysis
• Cons- Highly sensitive to inputs, Prone to overcomplexity
Relative Valuation Methods
• Primary Rationale – the markets are, on average, efficiently priced, and hence, one can arrive at the price of
an asset by looking at the average price the market is willing to pay for similar firms/assets
• Different Methods – Guideline Public Company Method, Guideline Transactions Method, and Prior
Transaction Method
• Each of the above methods is used in different circumstances, and can be implemented with different kinds
of Multiples
• Pros- Easier to ”sell”, offers view on current market environment
• Cons- Multiples prone to misuse, assumes market is always right 3
Discounted Cash Flow (DCF)
Methods
Basic Elements
• Discounting – A cash flow obtained in future is not as valuable as the same amount of cash flow today. Hence, future cash
flows need to be “discounted” in order to arrive at their “present value”
• The rate at future cash flows are discounted depends upon the risk inherent in the expected future cash flows
• In the context of firm valuation, cash flows need to after-tax
• Projected Equity Cash Flows are discounted with Cost of Equity to determine the Equity Value of the common stockholders of
a firm
• Projected Firm Cash Flows are discounted with Weighted Average Cost of Capital (WACC) to determine the Enterprise Value
of a firm

Source: Investopedia 4
DCF Valuation Inputs

• Projected Cash Flows- Cash Flows can be to equity shareholders or to providers of both equity and debt. Usually starts from
top line projections and building up from that.
• Discount rates- Discount rate should reflect the risk borne by the providers of capital. Equity cash flows should be discounted
at cost of equity and firm cash flows should be discounted at WACC.
• Terminal Value- Reflects the value of equity/firm beyond the forecasted period of cash flows. Assumes that the business will
grow at a set growth rate forever beyond the forecast period. Estimating this growth rate is a critical part of DCF valuation.

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Which Cash Flows to Project?

• As a minority investor, we can typically discount the future expected dividends and arrive at the equity value
• For firms which do not pay dividends, or for valuing a majority stake, we can discount the free cash flows to arrive at our
value
• The word “free” means that this cash is available to be distributed to the relevant stakeholders after meeting the
reinvestment needs of the company for its operations/expansion
Equity
View

Firm Cash to equity (C)

View

Post Tax Operating Earnings Cash to claimholders (A)

Debt repayment (B)

2 approaches-
Reinvestment
• Calculate ‘A’, subtract ‘B’ to arrive at ‘C’
• Calculate ‘C’ directly
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Discount rate

The discount rate, or the required rate of return (re) is the return shareholders demand to
compensate them for the time value of money tied up in their investment and the
uncertainty of the future cash flows from these investments.

The discount rate, should match the nature of cash flows which are being discounted. Cash
flows attributable to equity shareholders are discounted at the cost of equity whereas cash
flows attributable to the firm are discounted at Weighted Average Cost of Capital (WACC)

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Estimating discount rates
Cost of Equity

• Risk includes not only less than expected returns but also more than expected returns
• Diversifiable vs Non Diversifiable risk- In a diversified portfolio, firm specific risk goes
down since (a) very small % of overall portfolio (b) Same risk factor affects different sectors
in different ways and risk averages out to zero over time
• However, non diversifiable risk affects all the sectors in the same direction
• Prices of stocks are set by the marginal investor-most likely to be trading the stock and
setting the price. Often large institutions like mutual funds, hedge funds etc. Marginal
Investor is well diversified

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CAPM

• Why would a marginal investor stop diversifying?

o Transaction costs leading to marginal costs>marginal gains
o Active investors believing they can select undervalued stocks via private info
• CAPM Assumptions-
o 0 transaction costs
Removed reasons to stop diversifying
o No access to private info
• Result-
o Investors keep diversifying till they hold the market portfolio
o Risk of an asset becomes risk added to the market portfolio

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CAPM

Slope of regression measures the riskiness of the stock with respect to market value

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Risk free rate

• Risk free asset-

o Actual return=Expected return
o No default risk
o No reinvestment risk
• Countries that have significant default risk-
o Estimate default risk (spread) of a country by their bond ratings
o Look at the largest/safest firms in the country-is their debt traded?

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Equity Risk Premium

• Extra return demanded by investors in shifting their investment from

a risk free asset to an asset of average risk
• How to estimate?
o Historical averages- Premium would depend on how far back you take the
data, Choice of your risk free security and Arithmetic/Geometric average
o Implied equity risk premium-

Value of market index= ((Expected Dividend next year)/(K(e)-g))

Equity risk premium= K(e)- R(f)

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Estimating discount rates
Cost of Debt

• Debt which is listed on stock exchanges – Yield to maturity

• Debt which is rated but not listed on stock exchanges – Government
bond (for the relevant number of years as per instrument) + Default
Spread
• Neither of the above – Understand the credit profile and benchmark
against peers

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WACC

The weights E/(E+D) and (D/E+D) are calculated based on market values

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DCF Models
DDM
Dividend growth at a constant rate (g): (also known as Gordon Model)

OR

OR

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DCF Models
Pros and Cons

• Pros-
o Simple
o Few assumptions
o Managers often set dividends at sustainable levels. Cash flows are volatile and harder to
forecast
• Limitations-
o Equity claims to built up cash balances are not included
o Few firms pay consistent dividends
o Some firms pay higher dividends than cash balances by borrowing/new equity raise
which is unsustainable. DDM will overvalue the firm in this case

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DCF Models
FCFF Models

• FCFF= EBIT*(1-T) + Non Cash charges- Change in Non cash working capital - Capex
• Discounting FCFF at WACC gives the intrinsic Enterprise Value of the firm
• Enterprise Value= Market Value of Equity + Market Value of Debt + Market value of preferred
equity + Market value of minority shares – Cash and Cash equivalents
• Advantages of FCFF models-
o No need to worry about changing debt structure as FCFF does not consider after debt cash flow
o WACC less affected by leverage than Cost of equity

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DCF Models
FCFE Models

• FCFE can be thought of as potential dividends rather than actual dividends

• We assume the FCFE will be paid out to shareholders. Consequences-
o No cash buildup in the firm
o As a result of the above point, expected growth in FCFE will be due to growth in income from operating assets and not
from marketable securities (non core activities)
• FCFE= FCFF – Interest Expense*(1-T) + Net Borrowings
• Discounting FCFE at required return on equity gives the intrinsic equity value of the company
• Using an FCFE model requires one to estimate the net borrowings of a firm. In the absence of a plan by the
firm under consideration, estimating net borrowings is extremely subjective and difficult. In such a case, it is
more prudent to use FCFF based model to estimate the Enterprise Value first, and then arrive at Equity Value

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DCF Models

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Terminal Value

• Terminal value is the estimated value of a business beyond the explicit forecast period
• Critical part of the financial model, as it typically makes up a large percentage of the total value of
a business.

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Growth Rate
Where does g come from?

• g= Retention Ratio * Return on Retained Earnings

• Retention Ratio= 1-Dividend Payout Ratio=% of retained earnings not paid out as dividends
• Duration of growth phase
• Young, high growth firms with great potential- longer, say ~5-10 years
• Large firms in mature, stable industries- shorter, say <=5 years
• Limits on growth
• The stable growth rate cannot exceed the growth rate of the economy
• Think carefully about the stable growth rate as it is the single most important input which drives the value. Is the
terminal return on retained earnings greater than the cost of capital?
• If yes, does the firm have a competitive advantage over similar firms to justify this assumption? Usually the return on
retained earnings converges to industry average during stable growth phase as industry matures and becomes more
competitive

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Walk me though a DCF

• Forecast the free cash flows to steady state- Usually forecast the top line and
build up the other line items from that
• Sense check your forecasted cash flows- Ensure steady state assumptions are met
(ROC should remain stable, have a good reason if ROC>WACC in steady state etc.)
• Calculate the discount rate (Usually WACC if we are discounting FCFF)
• Calculate Terminal Value
• Discount the cash flows and the terminal value to present
• Calculate the Equity Value from Enterprise Value using the bridge
• Calculated the implied share price

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Prep Checklist
• Technicals-
• CFRA concepts should be clear
• Essential ratios (profitability, liquidity, efficiency etc.) used to evaluate performance of a business
• Valuation Methods- DCF, Relative Valuation
• Industry Prep-
• Current landscape- major players, recent developments, current trends
• Important performance parameters (operating and financial metrics) used in the Industry
• Relative valuation multiples used in the industry - Which multiples are used, and why they are used
• Regulations existing in the industry; recent changes, if any
• Recent major deals in the industry - not just knowledge about deal case facts, must develop your own opinion about the
deal (who got the better deal, your opinion about the value, how it affects the industry)
• Stock Pitch-
• Develop a clear opinion on its value
• Follow news events about it, about its leadership, major changes
• Outlook and valuation on the stock (how you think it will perform and whether it is a good buy currently)
• Company Specific Prep-
• Recent news and deals of the bank for which you have been shortlisted
• Formulate an opinion of the deal, and you may discuss with buddy calls whether the valuation is justified. You may also
ask questions about the deal if you have doubts or are unable to understand something 23