VALUATION

Introduction

• The value of a company depends on its ability to generate

future cash flows. We find the value by finding the present
value of its relevant future cash flow. The most important
question is how we define the relevant cash flow ? The most
common approach to define the cash flow is
• 1. Dividend 2. Free Cash Flow to Firm.
• When we find the value of a company by discounting the
expected future dividend, we call this process Dividend
Discount Model.
• When we find the value of a company by discounting the
expected Free Cash Flow to Firm, we call this process Free
Cash Flow Model.
 Intro to Free Cash Flows

• Free cash flow to firms(FCFF) is the cash

flow available to the firm’s common equity
holders after all operating expenses, and
necessary investments in working and fixed
capital have been made.
The name that Free Cash Flow is intended to signify
that firm is free to use this cash flow or firm has
discretion on how to use the free cash flow because
this is the cash flow that firm has after meeting all
operating expenses and necessary capital
expenditure in fixed assets and investment in
working capital ( current asset minus current liability)
Intro to Free Cash Flows

• Analysts like to use free cash flow valuation models (FCFF or

FCFE) whenever one or more of the following conditions are
present:
• the firm is not dividend paying,
• the firm is dividend paying but dividends differ significantly from the
firm’s capacity to pay dividends,
• free cash flows align with profitability within a reasonable forecast
period with which the analyst is comfortable, or
• the investor takes a control perspective.
 Intro to Free Cash Flows

• Common equity can be valued by either

• directly using FCFE or
• indirectly by first computing the value of the firm using a FCFF
model and subtracting the value of non-common stock capital
(usually debt and preferred stock) to arrive at the value of equity.
Finding FCFE

FCFF = (Sales – COGS-Operatng Expense including non cash

expense like Dep)*(1-tax rate)+ Dep- Capex – change in WC
FCFF can be found from Net Income
FCFF = NI + Depreciation + Int(1 – Tax rate) – Inv(FC) –
Inv(WC) or
FCFF can be found from EBIT

• FCFF = EBIT(1-tax rate) + depreciation – Cap. Expend. – change in

working capital
FCFF can be found from EBITDA

• FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv

FCFF can be found from OCF

• FCFF = CFO + Int(1 – Tax rate) – FCInv
Forecasting Future Cash Flow
• Forecasting free cash flows requires projecting future financial statement
and then from the projected financial statements, analysts find the
dividend or free cash flow.
• Usually analysts start with the reviews of the performance of overall
macro economy and try to build the expectation about the key
macroeconomic variables like interest rates, inflation, GDP growth rate,
export, import etc.
• Once analysts have made a projections for next 5-10 years, then they
narrow down their analysis to respective industry.
• In light of the macroeconomic review and expectation, analysts try to
determine the key trends of the industry like sales growth of industry,
industry profit margin, intensity of completion among the key competitors,
entry of new entrants, exits of existing players, expected changes in rules
and how they are going to affect the industry profitability etc.
Forecasting Future Cash Flow
• After macroeconomic review and industry analysis, analysts attempt to
value a company by projecting its financial statements first.
Key inputs to project the financial statements, among other things are
• Sales Growth
• COGS or gross profit margin
• Operating expense level or Operating Profit margin
• Capital Expenditure required to support the growth in sales
• Investment requirement in Working capital to support the growth in sales
• Terminal or sustainable growth of the company

Usually analysts starts with a review of financial performance for the last 3-
5 years, such as what is average gross profit margin of the company in the
last 5 years, what is the average operating expense as % of sales for the
last 5 years, average ROE, average EBIT margin, average asset turnover
etc.
Forecasting Future Cash Flow

• Then analyst combines the historical performance

inputs of the company with expectation of future and
trends in overall economy and industry to generate
forecasted financial statement of the company.
• In generating the projected financial statement,
analyst spend considerable time interviewing the key
management personnel of the respective company
to understand their business strategy, ability to
implement those strategy and previous track record
of the management staff.
 Example
Suppose you are an investment analyst and trying to determine the intrinsic value of XYZ Company
stock. After looking into the past financial performance of company, industry analysis and talking to the
management of the company, you have come up with the following assumptions about the future
performance of the company
• Initial sales of the company XYZ is 20,000 (assume this sales is at the end of December 2017).
• Sales growth rate for the next 5 year is expected to be 10% and terminal growth rate 3%
• Cost of Goods Sold as % of sales is expected to be 50%
• Operating expense as % of sales is expected to be 20%
• Net Incremental Capital Expenditure (Capital expenditure minus depreciation expense) is expected
to be 30% of increased sales.
• Incremental Working Capital expenditure each year is expected to be 20% of increased sales.
• Marginal Tax rate is 25%
• Target payout ratio 50%.
• Moreover assume that expected market return on DSEX is 13% and yield on 10 year Treasury
bond is expected to be 6%. You have computed beta of this company as 1.30 Cost of debt of this
company is 10%. From the balance sheet, you have found that total equity of this company is 4,000
and debt 4,000. Of the total asset, cash is 1,000 and number of shares outstanding is 500.
• Estimate the value of XYZ stock per share using FCFF and DDM model.
Finding Cost of Equity and WACC

• Cost of Equity ( re ) can be found using CAPM. According

to CAPM,
re = Rf + B *( Rm – Rf )
Cost of Debt can be found by using the following approach
Cost of bond ( rd ) = risk free rate + Bond risk premium
Bond risk premium is determined based on the credit rating
of the bond. For example a AAA rated bond will have lower
bond risk premium than a BBB rated bond.
Weighted average cost of capital is determined as followas
WACC = cost of equity * weight of equity + cost of debt
* weight of debt* (1- Tax rate)
Finding Terminal Value

• Terminal Value is found for a cash flow that is expected to

continue in perpetuity using the following formula

• Terminal Value n = CF n *( 1+g) /( r- g)

MARKET-BASED VALUATION: PRICE
MULTIPLES
• Price multiples are ratios of a stock’s market price to
some measure of value per share. A price multiple
summarizes in a single number a valuation relationship to
a familiar quantity such as earnings, sales, or book value
per share.
• The method of comparables involves using a price
multiple to evaluate whether an asset is relatively fairly
valued, relatively undervalued, or relatively overvalued in
relation to a benchmark value of the multiple.
• Choices for the benchmark value of a multiple include the
multiple of a closely matched individual stock and the
average or median value of the multiple for the stock’s
peer group of companies or industry.
 P/E Multiples
• The economic rationale underlying the method of
comparables is the law of one price—the economic
principle that two identical assets should sell at the same
price.
• The method of comparables is perhaps the most widely used
approach for analysts reporting valuation judgments on the basis of
price multiples.
• If we find that an asset is undervalued relative to a
comparison asset or group of assets, we may expect the
asset to outperform the comparison asset or assets on a
relative basis.
• However, if the comparison asset or assets themselves are not
efficiently priced, the stock may not be undervalued—it could be
fairly valued or even overvalued (on an absolute basis).
 P/E Multiples

• Earning power is a chief driver of investment value.

Earnings per share (EPS), the denominator of the price–
earnings ratio, is perhaps the chief focus of security
analysts’ attention.
• The price–earnings ratio is widely recognized and used by
investors.
• Differences in price–earnings ratios may be related to
differences in long-run average returns, according to
empirical research.
 P/E Multiples

The two chief definitions of P/E are trailing P/E and leading P/E.

• The trailing P/E (sometimes referred to as current P/E)

of a stock is the current market price of the stock divided
by the most recent four quarters’ earnings per share. The
EPS in such calculations are sometimes referred to as
trailing twelve months (TTM) EPS. Trailing P/E is the
price–earnings ratio published in stock listings of financial
newspapers.
• The leading P/E (also called the forward P/E or the
prospective P/E) is calculated by dividing the current
price by next year’s expected earnings.
 Issues with the use of P/E

When calculating a P/E ratio using trailing earnings, care

must be taken in determining the EPS number. The issues
include
1. transitory, nonrecurring components of earnings
that are company-specific;
2. transitory components of earnings due to
cyclicality (business or industry cyclicality);
3. differences in accounting methods; and
4. potential dilution of earnings per share
 P/B ratio as multiple

• In the P/E ratio, the measure of value, EPS, is a flow variable relating to the income
statement. By contrast, the measure of value in the P/B ratio, book value per share, is
a stock or level variable coming from the balance sheet.

• Intuitively, book value per share attempts to represent the investment that common
shareholders have made in the company, on a per-share basis.

• Because book value is a cumulative balance sheet amount, book value is generally
positive even when EPS is negative. We can generally use P/B when EPS is
negative, whereas P/E based on a negative EPS is not meaningful.

• Because book value per share is more stable than EPS, P/B may be more
meaningful than P/E when EPS are abnormally high or low, or are highly variable.
• As a measure of net asset value per share, book value per share has been viewed as
appropriate for valuing companies composed chiefly of liquid assets, such as
finance, investment, insurance, and banking institutions. For such companies,
book values of assets may approximate market values.
• Book value has also been used in valuation of companies that are not expected to
continue as a going concern
 Other Multiples

Price to Cash Flow ratio

Cash flow is less subject to manipulation by management than
earnings. Cash flow from operations, precisely defined, can be
manipulated only through “real” activities, such as the sale of
receivables.
• Because cash flow is generally more stable than earnings, price-to-
cash flow is generally more stable than P/E.
• Using price to cash flow rather than P/E addresses the issue of
differences in accounting conservatism between companies
(differences in the quality of earnings).
• Differences in price to cash flow may be related to differences in long-
run average returns, according to empirical research
Price to Sales Ratios
Sales are positive even when EPS is negative. Therefore, we can use
P/S when EPS is negative, whereas P/E based on a negative EPS is
not meaningful
Enterprise to EBITDA Multiples
Enterprise multiple, also known as the EBITDA multiple, is a ratio used to determine the
value of a company. The enterprise multiple looks at a firm in the way a potential
acquirer would by considering the company's debt, which other multiples (e.g., price-to-
earnings [P/E] ratio) do not include. Enterprise Multiple = Enterprise /EBITDA
Investors mainly use a company's enterprise multiple to determine whether a company
is undervalued or overvalued. A low ratio indicates that a company might
be undervalued, and a high ratio indicates that the company might be overvalued.
1. An enterprise multiple is useful for transnational comparisons because it ignores the
distorting effects of individual countries' taxation policies.
2. It's also used to find attractive takeover candidates since enterprise value includes
debt and is a better metric than market cap for mergers and acquisitions (M&A)..
3. Enterprise multiples are especially useful for valuation of heavy /capital intensive
companies
4. Enterprise multiples can vary depending on the industry. It is reasonable to expect
higher enterprise multiples in high-growth industries (e.g. biotech), and lower multiples
in industries with slow growth (e.g. railways).
EV = market value of common stock + market value of preferred equity + market value of
debt + minority interest - cash and investments.