Business valuation

What we will cover?

 Basic valuation concepts
 Purpose of valuation
 Methods of valuation – Trading
comparables, Transaction comparables
and DCF method of valuation using MS
excel financial model
Valuation: Meaning, Concept
 Meaning: ascertaining value – real,
intangible and financial assets
 Value – Price
 Value differs with time
 Merger/Acquisition

Buyback of shares Demerger

Why
Valuation ?
Test impairment IPO/FPO

Private placement Sale/Disinvestment

Valuation of Business Vs. Value
of Equity

Value of
Value of the - debt (less = Value of
operational cash) Equity
business i.e
Enterprise Bondholder value
Value
Shareholder value

Enterprise value
(Value of Business)
EV & Balance Sheet - a
comprehensive picture
 Cash +  Debt (MV)
Financial  Preference
 Cash
Invest-
equivalents - Shares
Ments, Invt
in associates +  Minority
 Non interest
controlled
Investment =
s+
Land  Non-core  Ordinary Equity
banks assets + value
 Enterprise
value (net
operating
assets: EV)
 Valuation
Methods

Earning based Market price

Asset based based

DDM

Net Asset Market

DCF Price/Price
multiples
Replacement Economic
value profit Market
Comparables /
Liquidation value EV transaction
Multiples multiple
Asset based – Net assets
Method
 Net Asset = Total Assets (other than
miscellaneous expenses and losses) –
Total External Liabilities

 Net assets = Shareholders funds(other

than revaluation reserve) – Miscellaneous
expenses and losses
Asset based method –
Replacement value, Liquidation
value
 Replacement value = Replacement cost of
assets - External liabilities

 Liquidation value = Sale value of assets –

External liabilities.
Earning based Approach
 Dividend Discount models – Walter and
Gorden models, One stage, two stage
models single period and perpetuity
models.
 Future expected dividends are discounted
at opportunity cost of capital to investors
to arrive a value of equity.
Earnings based approach - DCF
 Earning capacity of operating assets - Free
cash flow to firm or Free cash flow to
equity is ascertained. The same is
discounted at CC to arrive at value of
operating assets
 Earning capacity of operating assets is
arrived at using Economic profit or
concept of EVA and the same is
discounted to arrive at value of operating
assets
 Free Cash Flow
Free Cash Flow to the
Free Cash Flow to Equity
Firm

= Cash flow available to = Cash flow available to

Common stockholders Common stockholders

Debtholders

Preferred stockholders
FCFF vs. FCFE Approaches to
Equity Valuation

Equity Value

FCFE Discounted FCFF Discounted

at Required at WACC – Debt
Equity Return Value
 FCFF vs. FCFE Approaches to
Equity Valuation

FCFFt
Firm value  
t 1 1  WACC 
t

Equity value  Firm value  Debt value


FCFEt
Equity value  
t 1 1  r 
t
 Single-Stage Free Cash Flow
Models
FCFF1
Firm value 
WACC  g
Equity value  Firm value  Debt value

FCFE1
Equity value 
rg
Example: Single-Stage FCFF
Model
Current FCFF $6,000,000
Target debt to capital 0.25
Market value of debt $30,000,000
Shares outstanding 2,900,000
Required return on equity 12%
Cost of debt 7%
Long-term growth in FCFF 5%
Tax rate 30%
 Example: Single-Stage FCFF
Model
 MV(Debt)    MV(Equity)  
WACC   
 d r  (1  Tax rate) 
   r
 MV(Equity)  MV(Debt)    MV(Equity)  MV(Debt)  

WACC  0.25  7%  (1  0.30)  0.75 12%  10.23%

 Example: Single-Stage FCFF
Model

FCFF1
Firm value 
WACC  g
$6, 000, 000(1.05)
Firm value   $120.5 million
0.0123  0.05
Equity value  $120.5 million  $30 million  $90.5 million
Equity value per share  $90.5 million  2.9 million  $31.21
 Using Net Income to Determine
FCFF

FCFF  NI  NCC  Int 1– Tax rate – FCInv – WCInv

 Other Noncash Adjustments
Amortization • Added back
Restructuring Expense • Added back
Restructuring Income • Subtracted out
Capital Gains • Subtracted out
Capital Losses • Added back
Employee Option Exercise • Added back
Deferred Taxes • Added back?
Tax Asset • Subtracted out?
 Using EBIT and EBITDA to
Determine FCFF

FCFF  EBIT 1 – Tax rate   Dep – FCInv – WCInv

FCFF  EBITDA 1 – Tax rate   Dep  Tax rate  – FCInv – WCInv

 Using Cash Flow from Operations
to Determine FCFF

FCFF  CFO  Int 1– Tax rate – FCInv

 Calculating FCFE from
FCFF, Net Income, & CFO
FCFE  FCFF – Int 1– Tax rate   Net borrowing

FCFE from net income (NI) and FCFF:

FCFF  NI  NCC  Int 1 – Tax rate  – FCInv – WCInv
FCFE  NI  NCC – FCInv – WCInv  Net borrowing
FCFE from CFO and FCFF:
FCFF  CFO  Int 1 – Tax rate  – FCInv
FCFE  CFO – FCInv  Net borrowing
 Example: Calculating FCFF

EBITDA $1,000
Depreciation expense $400
Interest expense $150
Tax rate 30%
Purchases of fixed assets $500
Change in working capital $50
Net borrowing $80
Common dividends $200
 Example: Calculating FCFF from
Net Income
NI   EBITDA – Dep – Int 1 – Tax rate 

NI   $1000 – $400 – $150 1 – 0.30   $315

FCFF  NI  NCC  Int 1 – Tax rate  – FCInv – WCInv

FCFF  $315  $400  $150 1 – 0.30  – $500 – $50  $270

 Example: Calculating FCFF from
EBIT and EBITDA

EBIT  EBITDA – Dep  $1000 – $400  $600

FCFF  EBIT 1 – Tax rate   Dep – FCInv – WCInv

FCFF  $600 1 – 0.30   $400 – $500 – $50  $270

FCFF  EBITDA 1 – Tax rate   Dep  Tax rate  – FCInv – WCInv

FCFF  $1000 1 – 0.30   $400  0.30  – $500 – $50  $270
Example: Calculating FCFF from
CFO
CFO  NI  Dep – WCinv
CFO  $315  $400 – $50  $665

FCFF  CFO  Int 1 – Tax rate  – FCInv

FCFF  $665  $150 1 – 0.30  – $500  $270
 Example: Calculating FCFE from
FCFF, Net Income, & CFO
FCFE  FCFF – Int 1– Tax rate   Net borrowing
FCFE  $270 – $150 1– 0.30   $80  $245

FCFE  NI  NCC – FCInv – WCInv  Net borrowing

FCFE  $315  $400 – $500 – $50  $80  $245

FCFE  CFO – FCInv  Net borrowing

FCFE  $665 – $500  $80  $245
 Forecasting FCFF & FCFE
FCFF  EBIT(1  Tax rate)  ΔCapital expenditures  ΔWCInv

FCFE  NI  1  DR  FCInv  Dep   1  DR  WCInv 

 Example: Forecasting FCFF &
FCFE
Sales $4,000
Sales growth $200
EBIT $600
Tax rate 30%
Purchases of fixed assets $800
Depreciation expense $700
Change in working capital $50
Net income margin 10%
Debt ratio 40%
 Example: Forecasting FCFF &
FCFE
Sales growth  $200/$4000  5%
EBIT margin  $600 / $4000  15%

 $800  $700 
Incremental FC/Sales growth   50%
$200
$50
Incremental WC/Sales growth   25%
$200
 Example: Forecasting FCFF
Sales  $200  $4000  $4200
EBIT  $4200 × 15%  $630
EBIT(1  ax rate)  $630 × (1  30%)  $441
Incremental FC  $200  50%  $100
Incremental WC  $200  25%  $50
FCFF  EBIT(1  Tax rate)  ΔCapital expenditures  ΔWCInv
FCFF  $441  $100  $50  $291
 Example: Forecasting FCFE
Sales  $200  $4000  $4200
Net income  $4200  10%  $420
Incremental FC  $200  50%  $100
Incremental WC  $200  25%  $50

FCFE  NI  1  DR  FCInv  Dep   1  DR  WCInv 

FCFE  $420  1  0.40  $100   1  0.40  $50   $330

 Issues in FCF Analysis
Financial Statement Discrepancies

Dividends vs. FCFE

Effect of Shareholder Cash Flows & Leverage

FCFF & FCFE vs. EBITDA & Net Income

Country Adjustments

Sensitivity Analysis

Nonoperating Assets
 Simple Two-Stage FCF Models
n
FCFFt FCFFn 1
Firm value  
1
+
t 1 1  WACC t
 WACC  g  (1  WACC) n

n
FCFEt FCFEn 1

1
Equity value  +
t =1 1  r 
t
 r  g  (1  r )n

Illustration
 Example: Three-Stage FCF
Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for years 1 to 3 30%
FCFF growth for year 4 24%
FCFF growth for year 5 12%
FCFF growth for year 6 and thereafter 5%
WACC 10%
 Example: Three-Stage FCF
Models

Year
1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 12% 5%

FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4
PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5
 Example: Three-Stage FCF
Models

FCFFn 1 1
Terminal value 
 WACC  g  (1  WACC)n

$320.4 1
Terminal value   $3979
 0.10  0.05 (1  0.10) 5
 Example: Three-Stage FCF
Models
n
FCFFt FCFFn 1

1
Firm value  +
t =1 1  WACC t
 WACC  g  (1  WACC)n

Firm value  $118.2  $139.7  $165.1  $186.1  $189.5  $3979  $4777

Equity value  Firm value  Debt value

Equity value  $4777  $400  $4377

Equity value per share  $4377/300  $14.59

 Multiple based method
 Based on linking VALUE/PRICE with its DRIVERS.
 Multiple ratio of what you pay/what you get.

• EBIT
Earnings
• EBITDA

Enterprise
value or • Sales
Price of Revenue
• Sales growth
equity

• Employees
Non • Production
Financial quantity etc.
Most popular multiples
 Price earnings (PE) : Ratio of price per
share and earnings per share.
 Price to book value (PBV): ratio of price
per share to book value per share
 Price to Sales(PS): ratio of price per share
to sales value per share.
 By replacing price by enterprise value we
can get 3 more ratios, where
EV = Market value of equity + market
value of debt - cash
Understanding the multiples
 Define – understand its calculation
 Describe – cross section distribution
 Analyse – drivers of the multiples
 Apply – easily said than done
 Understanding multiples – an example
Mean multiples of the pharmaceutical sector for the period 200503-201003

PE, EV_PBIT AND EV_PBITDA fall within a range of 13-25 for the sector.
However, PBV, Mcap_sales and EV_sales are distributed in a range of
3.25-4.97. In the last four quarters from 2009-03 to 2010-03 the entire
sectors mean multiples have shown consistently increasing trend
 Steps in relative valuation
• Arrive at comparable companies
Peer Group • (Size, nature, growth, margin, risk)

• Annual reports, direct discussion with the company

Financial and
non financial
• Share price data, market and industry data
data

• Choice of multiple – PE, PBV, P-sales, EV/EBIT,

Arrive at EV/EBITDA, EV/Sales, EV/tonne, EV/subscriber etc.
benchmark
multiple and • Mean, median and harmonic mean, or regressions.
value
 Relative valuation an example – Basic facts
Astrazeneca Astrazeneca
Company Pharma India Abbott India Pharma India
Name Abbott India Ltd Ltd Lupin Ltd Merck Ltd Ltd Ltd Lupin Ltd Merck Ltd
YYYYMM 200502 200503 200503 200503 201002 201003 201003 201003
BSE_Close_Pr
ice 645.25 294.21 55.31 428.65 904.4 860.6 324.91 621.95
Quarter
Period 1 1 4 1 1 1 4 1
Sales 417.06 196.0908 1185.92 367.1156 821 414.1109 3641.08 480.4059
PBIDT 94.55 50.3198 145.79 108.2103 122.48 86.4423 818.61 113.0119
PBIT 79.35 45.8146 85.27 99.6353 113.27 80.4515 708.66 105.388
PAT 60.17 28.38 84.36 66.0118 75.24 52.9568 648.93 72.2348
Yearly_EPS 43.1 11.352 4.1 38.96 55.01 21.18 15.108 43.41
Market_Cap 985.94 735.53 2220.14 722.76 1237.22 2151.50 14448.75 1032.40

NO OF SHARES 1.53 2.50 40.14 1.69 1.37 2.50 44.47 1.66

EV_calculated 988.13 735.53 2660.78 722.76 1237.22 2151.50 15355.56 1032.40
BookValue 123.22 38.21 24.94 147.2 198.51 57.81 56.90 281.50
DEBT 2.19 0 440.64 0 0 0 906.81 0
ROE 0.3196 0.2970 0.1686 0.2660 0.2771 0.3664 0.2564 0.1546
Margin 0.19 0.23 0.07 0.27 0.14 0.19 0.19 0.22
Relative valuation an example – Basic facts

BSE_Close Mcap_sale
Company Name YYYYMM _Price PE PBV s EV_sales EV_PBIDT EV_PBIT
Abbott India Ltd 201002 904.4 16.44 4.56 1.51 1.51 10.10 10.92
Astrazeneca Pharma India
201003Ltd 860.6 40.63 14.89 5.20 5.20 24.89 26.74
Lupin Ltd 201003 324.91 21.51 5.71 3.97 4.22 18.76 21.67
Merck Ltd 201003 621.95 14.33 2.21 2.15 2.15 9.14 9.80
Median 18.97 5.13 3.06 3.18 14.43 16.30
Mean 23.23 6.84 3.20 3.27 15.72 17.28
harmonic 19.83 4.37 2.54 2.57 13.25 14.43
 Relative valuation - projections
BSE_Close_P
Company Name YYYYMM rice actual Yearly_EPS BookValue Sales PBIDT PBIT
Lupin Ltd 201103 415.35 18.158 70.6558 4420.86 975.6 845.63

Company Name YYYYMM PE PBV Mcap_sales EV_sales EV_PBIDT EV_PBIT

Lupin Ltd Median 201103 344.5160182 362.6654696 304.0658063 296.0536 296.1737516 289.4812687
Lupin Ltd - Mean 201103 421.7490029 483.3298783 318.608818 304.40696 324.5031637 308.2489189
Lupin Market data as on 31 March 2011
Open 417, H- 422, L- 409, C - 405

Lupin Market data as on 13 Jan, 2012:

Lupin NSE: 52 week high – Rs.494, 52 week low – Rs.393
Issues & Challenges
 How to arrive at comparable companies?
 Which multiple to use for valuation –
company specific.
 How to arrive at the benchmark multiple
for the next period?
 Dynamic nature of drivers.
 Weak market efficiency
Adjusted Present Value
 Illustsration