Valuation

Dr. Himanshu Joshi

Session 1
MDP on Spreadsheet Modeling for Business Valuation
May 19-20, 2016
 Why a Non-Finance Manager should
know Valuation?
Some Major Resource Allocation Decisions:
1. Launch of a New Product.
2. Enter a Strategic Partnership.
3. Invest in R&D.
4. Build a new Facility.
5. Brand Building Expenditures.
What is Critical for Decision Making in
Resource Allocation?
Some calculation of what that move is worth.
Estimated value is a critical determinant of
how it allocates resources.
And the allocation of resources, in turn, is a
key driver of a companys overall
performance.
 Learning Valuation: Why?
Rather than rely exclusively on finance
specialists, managers want to know how to do
valuations themselves. Why?
1. Executives who are not finance specialists
have to live with the fallout of their
companies formal capital budgeting systems.
2. Understanding valuation has become a
prerequisite for meaningful participation in a
companys resource allocation decisions.
 Approaches to Valuation
Three approaches to Valuation:
1. Discounted Cash Flow Valuation (DCF Valuation):
Relates the value of an asset to the present value of
expected future cash flows on that assets.
2. Relative Valuation: Estimate the Value of an asset by
looking at the pricing of comparable assets relative to
a common variables like earnings, cash flows, book
value, or sales.
3. Contingent Claim Valuation: Uses option pricing
models to measure the value of assets that share
option characteristics.
Discounted Cash Flow Valuation (DCF)
In Discounted cash flow valuation, the value of an
asset is the present value of the expected cash
flows on the asset, discounted back at a rate that
reflects riskiness of these cash flows.
Basis for Approach: we buy assets because we
expect them to generate cash flows for us in the
future.
Assets with high and predictable cash flows
should have higher values than assets with low
and volatile cash flows.
 Standard Valuation Method
Though executives estimate value in many
different ways, the past 35 years has seen a
clear trend toward methods that are more
formal, explicit, and institutionalized.
Discounted Cash Flow (DCF) analysis emerged
as best practice for valuing corporate assets,
and one particular version of DCF became the
standard.
 DCF Standard Method.
The Value of a business equals its expected
future cash flows discounted to present value
at the weighted-average cost of capital
(WACC).
Valuation is a function of three fundamental
factors:
1. Cash
2. Timing
3. Risk
 The Basic Logic of DCF Valuation

1. Cash Flow & Risk

Future value corresponds to future
business cash flows, CF. but business cash
flows are uncertain, so we discount
expected cash flows: E(CF)

()
Present Value = =0
1+
2. Timing:
Because business cash flows 3. Risk:
occur over many future Because business cash
periods, we locate them in flows are risky, investors
time, then discount and add demand a higher return:
them all. The discount rate, k,
contains a risk premium.
 Discount Rate: WACC

WACC = Ke x We + KdT x Wd
Ke = Rf + (Rm Rf)
KdT = Kd *(1-T)
Kd = Rf + Default Spread.
We = E/D+E
Wd = D/D+E
 WACC-based Standard Method
The cost of debt and cost of equity both are opportunity cost, each
consisting of time value and its own risk premium.
WACC also contains capital structure ratios and an adjustment
reflecting the term (1 minus Corporate Tax Rate).
Together these have effect of modestly lowering the WACC.
This in turn gives a higher present value than one would obtain by
discounting at a non-tax adjusted opportunity cost.
Note that to use WACC in this fashion is to rely on one term (1
minus Corporate Tax Rate) in the discount rate to automatically
make all the adjustments required by a complex capital structure.
 DCF Valuation
The cash flow will vary from asset to asset-
Dividends for stock
Coupon and face value for bonds.
After tax cash flows for business.
The Discount rate will be function of riskiness of the
expected cash flows:
Higher rates for riskier assets.
Lower rates for less riskier assets.
If the cash flows are risk free, do we still need to
discount them? At what rate?
Classifying DCF Valuation Models..
Three ways of classification:
1. Valuing a Business as a going concern as
opposed to a collection of assets.
2. Value equity in the business or valuing business
itself.
3. In the third, we layout two different and
equivalent ways of Doing DCF valuation in
addition to the expected cash flow approach- a
value based on excess returns and the adjusted
present Value.
 1. Going Concern versus Asset
Valuation
Asset Valuation: Value of business is sum of
values of the individual assets owned by the
business.
Is it correct? (Growing Firms like Face-book?)
Going Concern Valuation: A business or a
company is an ongoing entity with the assets
it already owns and the assets it expects to
invest in future.
Going Concern versus Asset Valuation
Accounting Balance Sheet vs. Financial
B.Sheet.
Assets Liabilities
Assets in Place:
Existing Investments: that
Generate Cash Flows Debt
today

Growth Assets:
Expected Value that will be Equity
created by future
Investments
Going Concern versus Asset Valuation
In Accounting Balance sheet Assets = Liability.
In Financial Balance sheet?
In financial balance sheet where growth assets
are more?
 Liquidation Valuation: Special Case of
Asset Valuation
In liquidation valuation we value assets based
on the presumption that they have to be sold
now.
Theoretically, it should be equal to the sum of
value obtained from the DCF valuations of
individual assets.
In Practical world?
2. Equity Valuation Vs. Firm Valuation.
Firm Valuation: value the firm with both the
assets in place and the growth assets.
The cash flows before debt payments and
after reinvestment needs are called free cash
flows to the firm, and the discount rate that
reflects the composite cost of financing from
all sources of capital is called the cost of
capital. (WACC)
 Firm Value
Cash Flows from Assets in
Place prior to any debt
payments but after firm
has reinvested to create
growth Assets
Discount Rate reflects the Cost of
Raising both debt and Equity
financing. In Proportion to their
use
Growth Assets:
Expected Value that will be created
by future Investments

Present Value is the Value of Entire Firm, and Reflects the value of all Claims on the
firm.
 Defining Free Cash Flows to the Firm-
FCFF
The free cash flows to the firm (FCFF)
represents the cash generated by the firm that
is available to all investors after having paid
taxes and meeting investment needs.
This money can be used to return money to
shareholders (either through dividends, or
share buyback), repay debt, acquire other
companies, provide extraordinary bonus to
key employees, and so on.
 FCFF
FCFF is also called unlevered cash flow since it
represents the total amount of cash available
to distribute by all suppliers of capital,
including debt holders.
This could also be interpreted as the free cash
flow that a firm without debt (unlevered firm,
or all-equity firm) would have.
 FCFF
FCFF is defined for each year as:
FCFF = EBDITA NWC Taxes CAPEX
OR
FCFF = Unlevered Net Income + Depreciation
CAPEX NWC
Unlevered Income = NOPAT = EBIT*(1-T)
 FCFF
In the FCFF method, we do not include any
debt-related payment in the cash flows. The
cost of debt will be considered only in the cost
of capital, and thus impact the company
valuation through the discount rate.
 Forecasting Future Cash Flows
In order to estimate FCFF, we need to
generate Proforma accounting statements for
future years.
Given the definition of FCFF, we need to
generate projections of income statement and
balance sheet going forward, so that we can
compute the different items needed for the
FCFF.
 Forecasting Future Cash Flows
Start with Sales Forecasting: It requires market
research analysis as well as well competitive
positioning, which allow us to compute Forecasted
Sales Growth Rate into the future.
Then, assumptions related to the Operating Profit
Margin, must be made. Margins might be higher or
lower that in the past for fundamental reasons, such
as:
Capacity Utilization
Unit Labour Cost
Inflation
Competition local and foreign
 Forecasting Future Cash Flows
Estimation of Net Working Capital: it can be
defined as percentage of sales, a fixed amount
per customer, or be based on monthly terms
(e.g., one month of credit to customers, two
months of inventories). It is important to always
look at Changes in net working capital.
Depreciation: Depreciation reflect past capital
expenditure made by the company and the
average useful life of equipment. Depreciations
will impact taxes.
 Forecasting Future Cash Flows
If Depreciation = CAPEX, we are assuming that
company is only replacing its assets, but not
growing its current capacity. Thus it is no growth
company.
In this case, we can assume that net working capital
is constant, and thus on annual basis the firm will
not change its receivables, inventory and payables.
Thus NWC = 0
In this particular case, the FCFF = Unlevered NOPAT
= EBIT *(1-T)
 FCFF Calculation Example..
Consider a company with:
Previous year revenues = $10,000
Estimated Revenue Growth = 5%, 4%, and 3% over the
next 3 years respectively.
COGS = 50% of Sales.
Selling, General and Admn. expenses = 15% of Sales.
Depreciation for next three years = $200, 210, and 218.
Tax Rate = 30%
Net Working Capital Requirements = 5% of Sales
Capex for next three years = $300, $294, $284.
 Proforma Income Statement
Revenues 10000
Growth in Rev 5% 4% 3%
COGS/Sales 50%
SG&A Exp/Sales 15%
Tax 30%
NWC/Sales 5%
Depreciation 200 210 218
Working Capital 500
Capex 300 294 284

Year 1 2 3
Revenues 10500 10920 11248
Cost of Goods Sold 5250 5460 5624
SG&A Exp 1575 1638 1687
EBDITA 3675 3822 3937
Depreciation 200 210 218
EBIT 3475 3612 3719
Taxes 1043 1084 1116
Unlevered Income 2433 2528 2603
EBIT(1-T) 2433 2528 2603

Working Capital Requirements 525 546 562.38

Changes in NWC 25 21 16.38
 FCFF Calculation

Calculation of FCCF under First Method FCFF = EBDITA - NWC - Taxes - CAPEX

EBDITA 3675 3822 3937

Minus Changes in NWC -25 -21 -16.38

Minus Taxes -1043 -1084 -1116

Minus Capex -300 -294 -284

FCFF 2308 2423 2521

Calculation of FCFF under Second Method FCFF = EBIT (1-T) + Depreciation - CAPEX - NWC

EBIT (1-T) 2433 2528 2603

Plus Depreciation 200 210 218

Minus Capex -300 -294 -284

Minus NWC -25 -21 -16.38

FCFF 2308 2423 2521

How Long is the Explicit or Forecasting
Period?
Since Companies are assumed to have an
infinite life, valuation is split into two
components:
1. The Explicit Period
2. Terminal Value
 The Explicit Period
In the explicit period, we compute of the FCFF for each
year. The cash flow forecasts should be based on sound
industry and company analysis, reflecting industry
trends, market research data, competitive pressures
and firm strategy.
The length of explicit period varies. It depends on our
scenario for the firm growth. It basically depends on
the length of time that one believes the company will
be able to grow at fast rates.
But eventually every company reaches a mature stage.
At this stage terminal value will be computed.
 The Terminal Value
Having computed the explicit period FCFFs,
one then needs to compute the terminal
value. The terminal value is estimated in the
last year of explicit cash flows and represents
sum of all the future cash flows that the firm is
going to generate, in steady state, thereafter.
 Terminal Value

TVt = FCFFt+1 = FCFFt x (1+g)

WACC - g WACC g

Where TVt is the terminal value expressed at time t. it

should be discounted to present.
FCFFt represents the free cash flow to the firm at time t.
WACC is the weighted average cost of capital
g is the constant growth rate that is expected in perpetuity.
 Example..
Suppose we are interested in computing the
terminal value for a company for which we
have estimated the first five years of explicit
FCFF:
1 2 3 4 5
Unlevered net 2433 2528 2603 2653 2706
Income
+ Depreciation 200 210 218 225 229
- CAPEX (300) (294) (284) (270) (275)
- Changes in NWC (25) (21) (16) (11) (11)
 Example..
The assumption is that after 5 years, FCFF is
expected to grow into perpetuity at 2%. The
cost of Capital (WACC) is 9.31%.
TV5 = FCCF5 *(1+g)/WACC- g
TV5 = 2649 *(1.02)/(0.0931 0.02) = 36963.
 Final Valuation

Assumptions

Terminal Growth Rate 2%

WACC 9.31%

No. of Outstanding Shares 1000

1 2 3 4 5 5

Unlevered net Income 2433 2528 2603 2653 2706

+ Depreciation 200 210 218 225 229

- CAPEX -300 -294 -284 -270 -275

- Changes in NWC -25 -21 -16 -11 -11 FCFF 6

FCFF 2308 2423 2521 2597 2649 36963

PV of FCFF 2111 2028 1930 1819 1697 23685

Value of Firm's FCFF 33270

Share Value 33
 Firm Valuation (Unlevered Firm)
Value of Shares vs. Terminal Growth
160

140

120

100

80

60

40

20

0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
 Firm Valuation (Unlevered Firm)
Share Value vs. WACC
90

80

70

60

50

40

30

20

10

0
0% 2% 4% 6% 8% 10% 12% 14% 16%
 Growth in Perpetuity
The free cash flow used in the constant
growth formula used for the terminal value
above must be a steady-state cash flow for the
year after the forecast period ends.
The assumption is that this cash flow will grow
at a constant steady-state rate in perpetuity.
 Growth in Perpetuity
Necessary calculations might be required for the capital
expenditures (CAPEX) and NWC, in order to get the Final FCFF.
The CAPEX in Steady State must maintain a certain growth, because
of two reasons:
1. It is necessary to replace assets that are being depreciated.
2. If one assumes a certain long term growth rate for sales, then the
assets of the company also have to grow over time.
Thus it is common to assume a certain constant long-term assets/sales
ratio, which means that in steady state efficiency of the assets will be
maintained.
If we assume growth in revenues for the calculation of the FCFF but do
not allow for growth in CAPEX, we would be assuming an infinite
improvement in the efficiency of the assets in place.
The same principle is applied to NWC.
FCCF : Terminal Value Growth Rate
It is advisable to dedicate substantial amount of time
and efforts on computing the steady-state growth rate.
In perpetuity, no firm can grow faster than the overall
economy. This means that the growth rate can never
be higher than the nominal GDP growth rate.
Also no firm can keep growing faster than the industry.
Finally growth rate can not exceed the cost of capital in
perpetuity.
Common practice is to use inflation rate as the
terminal growth rate. However, for certain declining
industries it is reasonable to assume negative terminal
growth rate.
 Equity Valuation
Second way is to just value the equity of the
firm.
The cash flows after debt payments and
reinvestment needs are called free cash flows
to the equity.
The discount rate that reflects just the cost of
equity financing. (ke)
 Equity Valuation

Cash Flows considered are cash

flows from assets, after debt
payments and after making
reinvestment needed for future
growth

Growth Assets: Discount Rate reflects only Cost of

Expected Value that Raising Equity financing.
will be created by CAPM Model
future Investments

Present Value is the Value of just the Equity, and Reflects the value of Equity Claims
on the firm.
 Inputs to the Discounted Cash flow
Models
Expected Cash Flows
The timing of the cash flows
Discount rate.
 1. Discount Rates
Discount rate used on a cash flow should reflect
its riskiness, with higher risk cash flows having
higher discount rates.
There are two ways of viewing Risk:
1. Likelihood that an entity will default on a
commitment to make payment such as interest
or principal due, this is called default risk. (when
looking at the debt, the cost of debt is the rate
that reflects this default risk.) KDT=KD*(1-T)
2. Variation of actual returns around the expected
returns. (beta and CAPM for Equity)
 2. Expected Cash Flows..
Dividend Discount Models
Free Cash flow to Equity Models.
Free Cash Flow to the Firm Models.
 3. Expected Growth
There are three generic ways of estimating
growth:
1. Look at the companys past and use the
historical growth rate posted by that company.
(peril: past growth may not continue).
2. Obtain estimates of growth from more informed
sources. (Co. Mgt, consensus of analysts).
3. How much the earning is reinvested back into
the firm and how well these earnings are
reinvested. (Retention Ratio* ROE)
 Relative Valuation..
How the market prices similar assets.
Thus, when determining what to pay for a house,
we look at what similar houses in the
neighborhood sold for rather than doing an
intrinsic valuation.
Extending this analogy to stocks, investors often
decide whether a stock is cheap or expensive by
comparing its pricing to that of similar stocks
(usually in the peer group).
P/E Ratio, P/Book Ratio, Price/Sales. Price/ARPU,
Price/SQRFT.
 The Methods of Comparable
The idea behind price multiples is that a stocks price
cannot be evaluated in isolation. Rather, it needs to be
evaluated in relation to what it buys in terms of
earnings, net sales, net assets.
Obtained by dividing price by a measure of value per
share, a price multiple gives the price to purchase one
unit of value.
EX.. Price/EPS = 20, means that it takes 20 units of
currency (say, Rs. 20) to buy one unit of earnings (say
Rs. 1 of earnings).
This scaling of price per share by value per share makes
possible comparison among various stocks.
 Methods of Comparable..

Stocks P/E Analysis

A 20 If they have similar risk, profit margins, and growth prospects, the security with the
B 25 P/E
Of 20 is undervalued relative to the one with P/E of 25.
 Example..
Company As EPS is $1.50. its closest competitor,
Company B, is trading at a P/E of 22. Assume that
companies have similar operating and financial
profits.
Q1. if company As stock is trading at $37.50, what
does that indicate about its value relative to
Company B?
Q2. if we assume that Company A stock should
trade at about the same P/E as Company Bs stock,
what will we estimate as an appropriate price for
company As stock?
 The Method based on Forecasted
Fundamentals..
If the DCF value of a stock is $10.20 and its forecasted EPS is $1.2,
the forward P/E multiple consistent with the DCF value is
$10.20/$1.2 = 8.5
The term forward P/E refers to a P/E calculated on the basis of a
forecast of EPS.
Thus, we can approach valuation by using multiples from two
perspectives:
First, we can use the method of comparable, which involves
comparing an assets multiple to a standard of comparison. Similar
assets should sell at similar prices.
Second, we can use the method based on forecasted fundamentals,
which involves forecasting the companys fundamentals rather than
making comparisons with other companies. (The Price Multiple of
an asset should be related to its expected future cash flows.)
 Justified Price Multiples..
The justified Price multiple is the estimated fair value
of that multiple, which can be justified on the basis of
the method of comparable or the method of
forecasted fundamentals.
Example.. Suppose we use price-to-book ratio (P/B) in
a valuation and find that median P/B for the companys
peer group, which would be the standard of
comparison, is 2.2. The stocks justified P/B based on
the method of comparable is 2.2.
If the current book value per share is $23 then, Price =
2.2*$23 = $50.60, which can be compared with its
market price.
 Justified Price Multiples..
(Fundamental)
Suppose that we are using a residual income
model and estimate that the value of stock is $46
(DCF estimate).
Then the justified P/B based on the fundamental
is $46/$23 = 2.0
This we can again compare with the actual value
of stocks P/B.

We can incorporate the insights from the method

based on fundamentals to explain differences
from results based on comparable.
 Price Multiples
1. Price to Earnings = Market Price per
Share/Earning Per Share
Rationales supporting the use of P/E Multiple..
a. Earning power is chief driver of investment value,
and EPS, the denominator in the P/E ratio, is
perhaps the chief focus of security analysts
attention.
b. The differences in stocks P/Es may be related to
differences in long run average returns on
investments in those stocks.
 P/E Multiple..
Potential Drawbacks:
a. EPS can be zero, negative, or insignificantly small relative to
price, and P/E does not make economic sense with zero,
negative, or insignificantly small denominator.
b. The ongoing or recurring components of earnings that are
most important in determining intrinsic value, can be
particularly difficult to distinguish from transient
components.
c. The application of accounting standards requires corporate
managers to choose among acceptable alternatives and to
use estimates in reporting. Doing so, managers may distort
EPS as an accurate reflection of economic performance.
 Alternative Definitions of P/E..
Trailing P/E: A stocks trailing P/E is its current
market price divided by the most recent four
quarters EPS.
Current P/E: to mean a P/E based on EPS for the
most recent six months plus the projected EPS for
the coming six months. This calculation blends
historical and forward looking elements.
Forward P/E: (leading P/E or prospective P/E): is a
stocks current price divided by next years
expected earnings.
 Application.
Use same definition of P/E to all companies and time
period under examinations.
Valuation is a forward looking process, so analysts
usually focus on the forward P/E when earning
forecasts are available.
When earnings are not readily predictable, a trailing
P/E may be more appropriate than forward P/E.
When the firm has undergone substantial changes in
terms of M&A activities, financial leverage, divestitures
etc., trailing P/E based on the past EPS is not
informative about future, thus not relevant for
valuation.
 What Influence P/E Ratio..
According to infinite period dividend discount
model
P = D1/(k-g) ------------(1)
Dividing eqn. (1) by expected earnings (E1):
P/E1 = D1/E1 Dividend Payout
Ratio
(k-g)

Required
Rate of Expected
Return growth rate
of Dividends
for the Stock
 P/E Ratio Depends upon:
Dividend Payout Ratio
Expected Required Rate of Return.
Expected Growth Rate in Dividends.
Example: Expected Payout Ratio of 50%.
Required Return = 12%, growth rate = 8%
If k = 13%
If g = 9%
If k = 11% and g = 9%
 Interpretation of the Relative
Valuation Techniques..
Step1. compare the valuation ratios (P/E, P/Cash
Flow, P/B) for a company to the comparable
ratio for the market or/and the stocks industry
to determine how it compare that is:
Is it similar or
Continuously at discount or Premium.
Step2. understand and compare what factors
determine the specific valuation ratio and
compare factors for the stock vs. the same factors
for market, industry..