Crasher 1 : Valuation

Finance and Investments Club

The Time Value of Money

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 The Time Value of Money

Would you prefer to

have $1 million now or
$1 million 10 years
from now?
Of course, we would all
prefer the money now!
This illustrates that there
is an inherent monetary
value attached to time. 3
 Example of PV of a Cash Flow Stream
• Joe made an investment that will pay $100 the first year, $300 the
second year, $500 the third year and $1000 the fourth year. If the
interest rate is ten percent, what is the present value of this cash flow
stream?
1. Draw a timeline:

$100 $300 $500 $1000

0 1 2 3 4

?
? i = 10%
?
?
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 Formulas
• Common formulas that are used in TVM
calculations:*
– Present value of a lump sum:
PV = CFt / (1+r)t OR PV = FVt / (1+r)t

– Future value of a lump sum:

FVt = CF0 * (1+r)t OR FVt = PV * (1+r)t

– Present value of a cash flow stream:

n

PV = S [CFt / (1+r)t]
t=0 5
 Enterprise Value
• EV = Market value of equity + Preferred stock + Minority
Interests + Market Value of debt – cash and cash
equivalents
• Takeover value of the company
• All the components are market, not book values
– However if market value of debt is not available, take the last
reported consolidated book value of debt
• Sum of claims of all the security-holders: debt holders,
preferred shareholders, minority shareholders, common
equity holders
• Better than market cap, since it also consider value of
debt, which needs to be paid by the buyer of firm.
 Enterprise Value

Source: http://aswathdamodaran.blogspot.com/2013/06/a-tangled-web-of-values-enterprise.html
Valuation methods
Relative Valuation
 Finding Comparables in industry
• Very complicated job
–Highly unlikely for another firm to have
the same business profile as my firm
–Cross-sectional comps
–Temporal comps
–Geographical comps
 Selection of Ratios
• Common metrics
– P/E Ratio - Share price/Earnings per share
– EV/EBITDA – Enterprise value/Operating Profit
• Common area of error
– If numerator is for the firm, denominator is also for the
firm – matching is important
– Equity value / EBITDA?
• NO! Enterprise Value / EBITDA, Equity Value / Earnings
• DCF gives intrinsic value
– Relative Valuation takes into account market views about
the particular asset
– Overall market is correct, however individual inefficiencies
do exist
Alternative specifications

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Discounted Cash Flow
Generic Valuation Model

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 Income Statement Description
• Revenue – COGS = Gross Profit
• Gross Profit – SG&A – other operating expenses =
EBITDA
• EBITDA – Dep – Amort (Tax Deductible, non-tax
deductible) = EBIT
• EBIT – Interest = EBT
• EBT – T = PAT
• PAT (Earnings) – Dividend = Retained Income
 Free Cash Flow
• FCF to the firm is a cash flow available for
distribution among all the security holders of a
company. They include equity holders, debt holders,
preferred stock holders and so on.
• FCF to the firm =
EBIT * ( 1- tax)
(+) Depreciation
(–) Capital Expenditure
(–) Increase in working capital
 Types of Free Cash Flow
Cash flows can be measured to

Just Equity Investors

All claimholders in the firm

EBIT (1- tax rate) Net Income Dividends

- ( Capital Expenditures - Depreciation) - (Capital Expenditures - Depreciation) + Stock Buybacks
- Change in non-cash working capital - Change in non-cash Working Capital
= Free Cash Flow to Firm (FCFF) - (Principal Repaid - New Debt Issues)
- Preferred Dividend

Free cash flow to Equity =

Free Cash Flow to Firm
(+) Net Debt (Amount borrowed less amount repaid)
(-) Interest
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 Cash flow Modelling
• Modelling is an important part of DCF Valuation.
• Following are the income statement items that needs to be
modelled to arrive at the Free Cash Flows
• Revenue
• Historical growth rate
• Top Down Approach
• Bottom Up Approach
• Variable cost items - COGS
• Material purchased as a percentage of Revenue
• Capital Expenditure
• Depends on Future strategy and Historical investments
• Working Capital
• Estimated as a percentage of Revenue (or) by forecasting
each item of the balance sheet
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Cost of Capital
Cost of Equity, Cost of Debt, Cost of Capital

• Cost of Equity
– Expected return for equity investors (opportunity
cost of investing in other assets)
• Cost of Debt
– Return for debt holders
– Use default spread
– Tradable bonds yield
• Cost of capital
– Combined effect of debt, equity and preference
capital
 Cost of Equity

CAPM E(R) = Rf +  (Rm- Rf) Riskfree Rate

Beta relative to market portfolio
Market Risk Premium

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 Beta

• Regression of the stock =

• Slope of regression measures the
riskiness of the stock with respect to
market value
 Factors affecting beta
• Type of business
– As already mentioned, more core the business(food, oil)
lower the beta normally
• Operating Leverage degree
– Higher operating leverage  higher variability in operating
income  higher beta
– Smaller firms with faster growth potential more riskier
than larger firms
• Financial Leverage
– Variance in net income  Equity investment risky  Beta
higher
 Cost of Debt
Method 1
• CoD = Interest paid/Total borrowings

Method 2
• Rf + Default spread
• Use the rating for this firm and then add the
default spread for that rating to Rf.

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 WACC

WACC = CoE x E/(D+E) + CoD x D/(D+E) where

(i) the weights E/(D+E) and D/(D+E) are based on market values
(ii) CoD = risk free rate + default spread

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Terminal Value
Ways of Estimating Terminal Value

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Terminal Value Scenarios

FI257 - Term IV 2011 - Kaustav Sen 33

Factors affecting Growth Rate

FI257 - Term IV 2011 - Kaustav Sen 34

 Growth Rate & Duration
• Where does g come from?
– g = Retention ratio × Return on retained earnings
• Duration of growth phase:
– young, high growth firm with great potential, just after IPO: shorter, say
<=5 years
– larger firm with a track record of delivering growth in the past: longer, say
10 years

• Limits on growth:
– The stable growth rate cannot exceed the growth rate of the economy but
it can be set lower.
– The stable growth rate can be negative. Then TV will be lower and firm
will disappear over time.
– If nominal values are used, the growth rate of the economy is the riskfree
rate.

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Annexure
 Acknowledgement
• The class slides of the following courses have been
used
• Corporate Financial Reporting – Prof., Sudhir Jaiswall
• Corporate Finance, Prof. Ashok Bannerjee, Prof. B.B.
Chakrabarti
• Corporate Restructuring, Prof. Ashok Bannerjee
• Business Valuation, Prof. Kaustav Sen
• In addition, material from a number of books has
been taken including
• Corporate Finance, Ross
• Investment Valuation, Damodaran
The Building Blocks of Valuation

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 Stable Growth Firms should …
• Have betas close to one
• Have debt ratios closer to industry averages (or mature
company averages)
• Have excess returns approach (or become) zero
– ROC -> Cost of capital and
– ROE -> Cost of equity.
– What does it mean for price multiples?
• Have lower growth and excess returns:
– Stable period payout ratio = 1 - g/ ROE
– Stable period reinvestment rate = g/ ROC

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 Which Growth Pattern Should I use?
• Stable Growth Model if
– large and growth <= growth rate of the economy
– or constrained by regulation
– has average risk & reinvestment rates
• 2-Stage Growth Model if
– large and growth <= overall growth rate + 10%
– or has a single product & finite life barriers to entry (e.g. patents)
• 3-Stage Growth Model if the firm is
– small and growth > overall growth rate + 10%
– or has significant barriers to entry into the business
– has firm characteristics that are very different from the norm

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 Growth and Terminal Value - 2
• Growth rate = Reinvestment Rate * Return on invested capital
+ Growth rate from improved efficiency
• For stable growth, the second term is zero (why?). Then
– Reinvestment Rate = Stable growth rate/ Stable period Return on
capital
• Is it okay to assume that firms can earn more than their cost
of capital in perpetuity? [ TV Scenario 3]
• Or should we argue that return on capital = cost of capital in stable
growth… [TV Scenario 2]
• What is the expected growth rate when you assume that
stable growth firms just make maintenance cap ex (replacing
existing assets ) to deliver growth?
• Can stable growth rate = inflation rate?
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