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Business Analysis and

V l ti
Valuation
IntroductiontoValuation
Prof.PitabasMohanty

Content
Module1:TheoryofDCFValuation(5Sessions)
M d l 1 Th
f DCF V l ti (5 S i )
Module2:PracticeofDCFValuation(56Sessions)
Module3:RelatedIssues(4Sessions)
M&AValuation
PrivateCompanyValuation
VentureCapitalValuation

Module4:NonDCFValuation(3Sessions)
MultiplierMethods
RealOptionsMethod

ClassTestsin2sessions
Session5or6(Quiz1)
Session12or13(Quiz2)

About the Course


Pedagogy
Lectures(Dobringyourscientificcalculatortoall
(
gy
theclasses))
CaseDiscussions(4Cases)
Project(GroupProject)
Howtoselectthe2companies

GroupProject
Groupsizeof5.Eachgrouptovalue2companiesfromthesamesector.Atleast
oneIndiancompany.
SubmissiontobemadewithinaweekafterModule2isover.Thegroupwill
S b i i t b
d ithi
k ft M d l 2 i
Th
ill
looseonegradepointforeveryweeksdelayedsubmission.
Yourgroupmaybeaskedtomakeasurprisepresentationoftheinterimprogress
reportintheclass.Randomlyselectedmembersofthegroupmaybe
interviewedtoknowtheprogressmadeintheproject.

CourseMaterial
Photocopiesofmybook(tobepublished)
ClassSlides(Canbedownloadedfrommywebsite)

Evaluation (Relative Grading)


Evaluation
E l ti
TwoClassTests:30%
Firsttestaftermodule1
Secondtestaftermodule2

Project:25%
ClassAttendance:10%
5marksforclassattendance(@1markforeveryclassattendedforwhich
attendance is taken)
attendanceistaken)

Endterm:35%
Additionalassignment(shortpaperfortheFPMstudents):25%
Meetmeinmyofficeseparatelyfordetails.

Code of Conduct
Nocellphonetobeused.
N
ll h
t b
d
Ifyouarefoundusingaphone,phonewillbeconfiscated.

Nocopyinginquizzes,examsandproject.
Allreferencesmustbeappropriatelyreferencedattheendofthepage(ina
ll f
b
i l
f
d
h
d f h
(i
footnote).
Ifyouhavecopiedandpastedapicturefromawebsite,thesourceofthe
website(anddateaccessed)mustbeputnexttothepicture.

Norequestforpostponementof
Quizzes
Submissionofdeadlines

Ifyourequestforextensionofdeadlineorpostponementofquizzes,
youwillgetFinthatparticularcomponent.

To Understand Company
p y Valuation You
Must be an Expert in
CorporateFinance
C
t Fi

TimeValueofMoney
RiskandReturn
Stock and Bond Valuation
StockandBondValuation
CapitalStructureTheory

FinancialAccounting
IndustrialEconomics
I d t i lE
i
Statistics(RegressionAnalysis)

Answer these questions


questions
Aparticularriskispriced.Whatdoesitmean?
A
ti l i k i i d Wh t d
it
?
Separationtheoremholds.WhatdoesitmeaninthecontextofMM?
Differencebetweenagoodcompanyandagoodstock
Astockisexpectedtogive50%return.Therequiredrateofreturnis
20%.Whatisthedifference?
D0 =Rs.5.D
Rs.5. D1 =Rs.7.Theexpectedgrowthrateindividendis6%.The
Rs.7. The expected growth rate in dividend is 6%. The
requiredrateofreturnis12%.Whatisthecumdividendstockprice?
Thegrowthrateinthedividenddiscountingmodelreferstothe
growth rate in i) sales, ii) profit, iii) dividend.
growthrateini)sales,ii)profit,iii)dividend.
YouarevaluingAirtel.CanyouusePEratioofSingtel asa
benchmark?
Whathappenstothecostofcapitalasthedebtratioincreases?
What happens to the cost of capital as the debt ratio increases?

Different Valuation Methods


DiscountedCashFlowMethod
Di
t d C h Fl M th d
FCF,CCF,FCFE,APV,EVA,DDM,etc.allfallinthiscategories

RelativeValuationMethod
AlsoknownasMultiplierMethod
l k
l i li
h d

RealOptionsValuationMethod
CostMethod

Where does FCF Method g


give us
Unsatisfactory Answer?
WhereFCFsarenegative.
Wh
FCF
ti
Whenafirmhaslotsofunutilized(underutilized)assets
Whenafirmhasrealoptions
Thereisnoguaranteethatanythingwillemergeasunder orover
valued.Itispossiblethatyoufindallthestockstobeovervaluedata
point.Thiscanbeaproblemtothefundmanagersandanalystswho
aretrackingstocksfromasector.

Relative Valuation Method


Here,wevalueanyassetbylookingatthevaluesofcomparable
H
l
t b l ki
t th
l
f
bl
assets(lookingatpricesrelativetoearnings,cashflows,bookvalue,
etc.)
Atypicalrelativevaluationmodelwouldworkasfollows:
A typical relative valuation model would work as follows:
Forecastanaccountingnumber(X)andfindhowmuchvaluethemarketis
willingtoputperunitofX.GettheValuetoXratio.
Examples:
p
PriceEarningsRatio
PricetobookRatio
PricetosalesRatio(Whatdoyouthinkthisratiomeasures?)

Examples
Sales

Earnings

BookValue

MarketValue P/S

P/E

P/B

HP

$84,229

$7,264

$38,526

$115,700

1.37

15.9

3.0

Lenovo

14,590

161

1,134

6,381

0.44

39.6

5.6

Dell

61 133
61,133

2947

3 735
3,735

$ Figures in Millions Market Value figures are as of end August 2008


$FiguresinMillions.MarketValuefiguresareasofendAugust,2008.

Real Options Method


Youhaveabrillianttechnicalidea.Youwanttoknowiftheidea
Y h
b illi t t h i l id Y
tt k
if th id
makescommercialsense.
YouapproachaVCforaRs.10millioninvestment.Thereisa90%
chance this venture will not succeed There is a 10% chance it will
chancethisventurewillnotsucceed.Thereisa10%chanceitwill.
Iftheideaturnsouttobecommerciallyviable,thentheVChasthe
solerighttomaketherequiredadditionalinvestmentsnextyear
(around Rs 100 million) The NPV of this investment will be Rs 400
(aroundRs.100million).TheNPVofthisinvestmentwillbeRs.400
million.
Whatisthevalueofyourinvestment?

Real Options Valuation Model


ImagineyouarevaluingthesharesofanewTVchannelthatjust
I
i
l i th h
f
TV h
l th t j t
boughtthesoleviewingrightsinIndiaforthenextmovieofHimesh
Reshammiya for2years.
Or,youarevaluinganewpharmaceuticalcompanythathasinvested
Or you are valuing a new pharmaceutical company that has invested
Rs.50millioninanewdrug.Itisinadvancedstageoftheresearch
process.Yettogetpatent.Ifitgetsthepatent,itsvaluewillbeRs.50
crores. If it does not, it probably will file for bankruptcy.
crores.Ifitdoesnot,itprobablywillfileforbankruptcy.

R
Recap
off DDM and
d MM
BusinessAnalysisandValuation(BAV)

Dividend Discounting Model


Wediscountactual(potential)dividendatrtoobtainthestockprice.
Assumptionnormallymadeaboutr:

Investorisdiversified
Investor
is diversified
rremainsconstantovertime
Neitherassumptionisneeded.Buttheysimplifythecalculations.
risnormallycomputedusingCAPMequation.
ristherequiredrateofreturn andnottheexpectedrateofreturn.Inan
efficientmarket,onecan,ofcourse,usethesetwotermsinterchangeably.
Example:ExpectedP1(exdividend)=$105.ExpectedD1=$5.Youneedaminimum
returnof10%fromthestockbasedonitsrisk.Thisistherequiredrateofreturn.Sothe
maximum price you should be willing to pay for the stock today is $100 Suppose the
maximumpriceyoushouldbewillingtopayforthestocktodayis$100.Suppose,the
stockisundervaluedandtradesat$90.Thenyourexpectedreturnis20/90=22.22%.

Constant Dividend

Constant Growth in Dividend

An Example

Example contd
Example,
contd.
Iftheexpectedgrowthrateis0,thenthepayoutratiowillbe100%.
If th
t d
th t i 0 th th
t ti ill b 100%
Theexpecteddividendpersharewillbe$10.Thepricewillbegiven
by:P0=10/0.2=$50pershare.
SincetheROEandtherequiredrateofreturnrareequal,growth
Since the ROE and the required rate of return r are equal growth
willhavenoeffectonthestockprice.
BookValuepershareisdefinedasNetWorthdividedbythenumber
of shares
ofshares.
Forthiscompany,thebookvalueisgivenby:$100million/2million=
$50pershare.Sincethepriceisalsoequalto$50pershare,the
price to book ratio is 1
pricetobookratiois1.
Infact,whenevertheROEandrareequal,thePBVratiowillequal
1.Thatiswhy,1issometimesusedasthebenchmarkPBVratio.

What if the Payout Ratio and ROE


change
g over time?
Net Worth (yearend)

Year0

Year1

NW0 (1)

NW0 + PAT1(1b1)
(5)

Year2

Return on Equity*

ROE1 (2)

ROE2 (6)

Net Income

PAT1 =
(NW0 ROE1) (3)

PAT2= [NW0+PAT1(1
b1)]ROE2 (7)

Payout Ratio

b1 (4)

b2 (8)

NW0 PAT1 (1 b1 ) ROE 2 NW0 ROE1

ROE 2 (1 b1 )

NW0 ROE1
( ROE 2 ROE1 )
...2(5a )
ROE1

Multi stage Growth Model


Multi-stage
Infosys
InfosyspaiddividendofRs.63persharefortheyearending31March,
paid dividend of Rs 63 per share for the year ending 31 March
2014.Analystsexpectthelongtermprofitgrowthratetobe14.19%for
Infosys(Source:
http://in.reuters.com/finance/stocks/analyst?symbol=INFY.NS).The
projectedgrowthratesfor2015and2016are11.14%and13.82%,
respectively.
Therequiredrateofreturnis13.63%.Letsassumetheterminalgrowthrate
to be 6%
tobe6%.
WhatistheintrinsicvaluepershareofInfosys?IttradesaroundRs.3,160.
Canweusetheprofitgrowthrateasaproxyforthedividendgrowthrate?
TheanswerisNO,iftheprofitgrowthratechangesfromyeartoyear.
Th
i NO if th
fit
th t h
f
t

ThetrickistofindtheimpliedretentionratiobydividingtheprojectedROE
withthegrowthrate.Thencomputethepayoutratioandfinallyprojectthe
dividend.
dividend.

Intrinsic Value per share

DPS
g
Price

2014
63
1 180 83
1,180.83

2015
2016
2017
2018
2019
2020
70.0196 79.69573 91.00455 103.9181 118.6641 125.7839
11.14% 13.82% 14.19% 14.19% 14.19%
6.00%
1648 89
1648.89
2014
63

DPS
g
Price
1,180.83
ROE
25.83%
EPS
186.49
P
PayoutRatio
R i
0.3378197
0
3378197
DPSAdjusted
63
CorrectIntrinsicValue
2,416.35

2015
2016
2017
2018
2019
2020
70.0196 79.69573 91.00455 103.9181 118.6641 125.7839
11.14% 13.82% 14.19% 14.19% 14.19%
6.00%
1648.89
25.83% 25.83% 25.83% 25.83% 25.83% 25.83%
207.2691 235.912 269.3879 307.6141 351.2645 372.3404
56 86% 46.50%
56.86%
46 50% 45.06%
45 06% 45.06%
45 06% 45.06%
45 06% 76.77%
76 77%
117.86
109.70
121.40
138.62
158.29
285.85
3,747.18

Net Present Value of Growth


Opportunities (NPVGO)

Example of NPVGO
ThenetworthofZLimitedason31.3.2015isRs.100million.TheROEis
20%.Therefore,theprofitaftertaxfortheyearended31.3.2016is
Rs.20million.Therequiredrateofreturnis16%.Thereare4million
shares outstanding
sharesoutstanding.
ThevalueofthestockisRs.31.25intheabsenceofgrowth.
ThevalueincreasestoRs.34.09iftheprojectedgrowthrateis5%.
SotheVGOisgivenby:
VGO=Rs.34.09 Rs.31.25=Rs.2.84
ThisisactuallyequaltothepresentvalueoftheNPVsofthenewprojectsthe
co pa y s go g to est to ac e e 5% g o t .
companyisgoingtoinvestintoachieve5%growth.

NPVGO and Price


Price-Earnings
Earnings Ratio

Understanding Modigliani and


Miller (MM)

Some Terminology
Valueorenterprisevalue?
V l
t
i
l ?
Businessriskandfinancingrisk
Unleveredcostofequity(unleveredbeta)
Leveredcostofequity(leveredbeta)

MM without Tax

MM in the presence of Tax