Discounted Cash Flow

-Ashish Chopra -August 06, 2011

We value because of markets mistakes

When take the DCF approach we assume:
Markets make mistakes We can find those mistakes Markets over a period of time will correct those mistakes!! [HOPE not in your control!!]

Hence, give 1.5-2 years time frame. Perform DCF with a long term investment horizon 3-6 months horizon? DON T waste your time and effort in DCF!!

You are lucky IF

There are enough data disclosures Predictability is simple And investment horizon is long term

Before you start a DCF.. Remember

2 Propositions
Cash Flows have be positive at some time in future The earlier the better!

A recap of Capital Budgeting

2 ways of Valuing a business

Valuing the whole business
Discount rate Cost of Capital (COC/WACC) Approach?

Valuing equity of the business

Discount rate Cost of Equity Approach?

3 Potential mistakes in DCF

THE STRICT DONT S
Calculating CF to Equity and Discounting at Cost of Capital Calculating CF to Firm and Discounting at Cost of Equity Calculating CF to Firm and Discounting at Cost of Equity . And forgot to subtract DEBT!! Double Trouble

Implications in each of the three??

Dealing with Cost of Debt

What debt do you use? Only long-term? All debt? (long term + short term)? All liabilities? (all debts + creditors & provisions)? How do you treat leases? (Remember this slide. Its gonna come to haunt to again some time later!!)

When valuing an Acquisition .

..Which discount rate do you use? COC of Target? COC of Acquirer? COE of target? COE of Acquirer? RISK THAT YOU ARE TAKING IS RISKINESS OF THE TARGET

Steps in DCF
Calculate Discount Rate

Estimate current earnings and cash flows

Estimate growth rate to arrive at future earnings and cash flows

Stable growth rate assumption (For terminal value calculation)

Choose the right model (FCFF/FCFE)

DCF Pillars

Cash Flows from existing assets

Growth rate of Cash flows

When will my company achieve stable state growth rate? What will be that growth rate?

What is the right discount rate?

2 Approaches + 3rd Traditional Approach

Dividend Discount Model

The third approach.. Actually the first! Same as cash flows to equity But stricter definition of cash flows The definition: Cash Flows are nothing but cash flows paid out as dividends to the shareholders

The problem with DDM

We are looking at what ACTUALLY gets paid out instead of what can POTENTIALLY be paid out Some companies cant pay out dividends But that is no problem.. The bigger problem is: Some companies DON T pay dividends. So you must calculate what CAN get paid out rather than what IS paid Welcome to FCFE!

FCFE
While calculating PAT, deduct the interest costs While calculating Free Cash Flow to Equity, deduct principal repayments on loans as well So you have taken care of Interest payments on Loan + Principal repayments on loan So all free cash flows left are cash flows to the Equity holders

FCFF
When dealing with Free Cash Flow to Firm, Do not subtract the interest costs Do not reduce the principal repayments

WHY?

DCF STEP 1: ESTIMATING DISCOUNT RATES

Definition
Cost of Equity Prefer CAPM Cost of Debt

Cost of Capital

Remember
Spend more time on cash flows and growth rate than on discount rate When estimating nominal cash flows, use nominal discount rates When estimating real cash flows, use real discount rates Risk free rate is generally a nominal rate

CoE Cost of Equity

In any risk and return model in finance:
Look at risk through the eyes of a marginal investor

Marginal investor:
They trade in the stock They own a lot of stock

So ask how much risk will the marginal investor add to his/her portfolio on owning the stock

CoE Cost of Equity

CAPM Model to calculate cost of equity CoE = Rf + (Rm Rf)
Rf = Risk Free Rate = Measure of risk in the stock Rm Rf = Equity Premium (Where Rm is the market rate of return

Estimating Rf
Necessary conditions for risk free rate
No default rate No reinvestment risk

Which government bond to use?

1 year? 5 year? 10 year?

Bond rate or Bond yield? What about other countries?

Estimating Rm Rf: Based on Historicals

Meaning: What is the premium that markets demand Can use historical average Problems
Premium over which Government bond? How far back in history do you go? Which average do you use?

Huge standard errors may prove the whole exercise counter-intuitive

An Example
US markets 78 year data

Standard Deviation = 20% Standard error = 20% / SQRT(78) = 2.26% Thus, if Rm Rf = 3, it can range from range from 0.74 to 5.26!!

Estimating Rm Rf: Futuristic Approach

Treat Stock Market Index (Sensex/Nifty) as a bond Check its Value (say Sensex = 18,000) Check the dividends payout % on an average (last 5 years, say 3%) Calculate the expected cash flow to investor in index (3% * 18,000 = 540) Estimate earnings growth of the index Give the bond treatment

The BOND Treatment

Suppose index growth rate is 10% 18,000 = 540 + (540)(1.1) + 540(1.1)2 1 (1+x) (1+x)2 What this is x? X = Rm! Therefore you know Rm, You know Rf, so you know the equity risk premium!

Estimating Beta
Remember always: Beta measures the undiversifiable risk in a stock

Regression Beta The simplest and most commonly used method

The method:
Regress the changes in stock price upon the changes in index price The slope of the straight line is the correlation hence the beta

Problem with Regression Beta

Slope has a standard error It is backward looking (historical values) Incorrect estimate if future leverage of the firm is significantly different than the past

Solution: Bottom-up approach

What kind of a business your company is in?

3 Determinants of Beta: What is the proportion of fixed costs?

What is the financial leverage of your firm?

Solution: Bottom-up approach

Break the company down into its businesses

Find the publicly available beta of each business

Estimate value derived from each business (Value and not Revenue)

Total beta of company is weighted average for weights of Values

Find levered Beta

Solution: Bottom-up approach

UL L=

Pure UL

* (1 + FC/VC)

* (1 + (1-t)(D/E))

beta obtained in step 4 (previous slide) UL = Unlevered Beta L = Levered Beta FC = Fixed Costs VC = Variable Costs t = Tax Rate D/E = Debt-Equity Ratio (Leverage)

Pure =Pureplay

Advantages of Bottom-up Beta

Reduces the Standard Error Business of the firm reflected in its risk Historical stock prices not needed

Few add-ons
Adjust your Beta for cash (one way is by taking net debt) Cant find comparable companies?
Expand Geographically Move up and down the value chain OR Find companies with similar financial metrics!

That s the bottom-up process

USE REGRESSION BETA

Cost Of Equity CoE: Review

CoE = Rf + (Rm Rf ) Rf Yield on 10 year Govt

Rm Rf Historical/Implied

Regression/Bottomup

Cost of Debt
Rate at which you can borrow LONG TERM, TODAY How to measure?
Yield on a corporate bond? Interest rate expense in P&L?

Answer: Default spread over Risk free rate

Few issues
What about subsidized debt? What if there is no credit rating?

Practically..
Net Interest Expense in P&L

Work-out the gross expense

Look up at the average debt on the books

Calculate the interest rate

The calculated interest rate is your cost of debt!!

Finally Cost of Capital

Weighted Average sum of CoE and CoD

Which weights to use? Market weights or Book weights?

Market weights

Why?

Estimating Cash Flows

The Formula

Check for three things

As far as possible, get most updated numbers
Last 12 months Balance sheet numbers may not be available

Normal earnings Expenses in Misplaced categories

Operating expenses Financial expenses Capital Expenses

Correct Accounting Earnings

Treating Leases
Fixed contractual payments hence debts Look out for future lease payment obligations Calculate the PV @ pre-tax discount rate Add this as liability on the BS So you need to add an asset! Fixed Asset! So you will have to depreciate this asset!!!!!!!

Working out the numbers

Correct Accounting Earnings

R&D designed to create benefits for many years
Expensed out in P&L Lesser assets, Higher ROE! Bigger problem license to play games with earnings Treat as capex Amortize over a certain number of years, remember to adjust the tax benefits

R&D Treatment

R&D Treatment
No difference in free cash flows

What reduces from opex gets added to capex!!

Then why all the trouble??

To obtain what old methods of accounting do not give you a sense on growth rates

Few other likely adjustments

One-time expenses (non-recurring) Accounting Malfeasance Negative Cash Flows arising due to:
Transient problem Cyclical Young company Financial leverage Operating issues

Lastly What tax rate?

Effective?

Marginal?

Net Capex
Net Capex = Capex Depreciation Prefer Net capex rather than treating capex and depreciation separately For any company to grow, it needs to invest So if your company is fast growing, this figure should be higher

Estimating Net Capex

Expanded Definition:
All investments going into creation of long term assets

Capex should include

R&D Expenses Acquisition Expenses

R&D Expenses
Remember you re-categorised them into capital expenses from operating expenses earlier Capex Adjusted for R&D:
Net Capex + Current years R&D expenses - Amortization

Acquisitions
Capex adjusted for Acquisitions:
Net Capex + Acquisitions money

Most firms may not acquire on an yearly basis Look into cash flows for acquisitions What about stock based acquisitions?

Why is this Adjustment Important?

Cisco grew from US$4b in 1991 to US$ 400b in 1999 Vision: To identify and acquire promising technologies and turn them into commercial successes 15-20 acquisitions every year Simpler to adjust for acquisitions for CISCO. What about those which acquire 1 company in 4-5 years?

Why is this Adjustment Important?

Capex (US$584m) Depreciation (US$486m) = US$98m net capex (From cash flow statement) + R&D Expense (US$1,594m) R&D Amortization (US$485m) + Acquisitions (US$2,516m) TOTAL NET CAPEX = US$3,273m!!

Why is this Adjustment Important?

GE grew at 9% from 1985-199 4.5% organic, the remaining 4.5% growth came from Acquisitions Analysts assumed 9% growth every year, but assumed internal capex as total capex without accounting for acquisition costs So, cash inflows assuming 9% growth, without cash outflows of Acquisitions! GE was always an overpriced stock!

INCREMENTAL WORING CAPITAL

Working Capital
Accounting Definition: CA CL

Valuation Definition: Non Cash CA Non Debt CL

1. Why Non-Debt?
Include all debt in the calculation of your cost of debt and cost of capital

Therefore, including cash outflows here will lead to double counting How double counting: Higher debt will Increase beta and hence COC and hence FCF PV will be lesser. So don t reduce the FCF again as debt repayment will be cash outflow

2. Why Non-Cash?
IWC = WCt WCt-1 IWC = (CA-CL)t (CA-CL)t-1 IWC = (CAt-CAt-1) (CLt-CLt-1) IWC = ICA-ICL Therefore if CAt is high, ICA will be high, IWC will be high IWC is high implies cash flow is less Thus, Current assets like inventory are a drain on cash flow as they tie-up cash

2. Why Non-Cash?
Remember wasted assets are drain on cash flows Cash 30 years ago was like Inventory was a wasted asset!! Deposited in non-interest bearing checking accounts Today cash is invested in liquid marketable securities earning upward 4% returns Companies today are matured about rolling cash

2. Why Non-Cash?
Large retailer constantly generating cash flows

Walmart cash registries cleared every hour!

Why not at the end of the day on closing the shops?

Because they will loose 8 hours of interest!!

2. Why Non-Cash?
Thus, cash is not a wasted asset anymore!! More so in emerging markets Higher the inflation, lesser the value of your cash tomorrow? In such a scenario, take the example of Zimbabwe inflation rate?

Estimating IWC
Volatile figure, changes every year directionally Don t look at any 1 year, look over multiple years, 3-5 Also, look at Working Capital trend as a % of revenues

Estimating IWC
IWC reduces your cash flows But if IWC comes out to be negative for 3-5 year horizon that you looked at, then effect on cash flows will be positive (CL >>CA) Can you choose this negative IWC going forward? Not sustainable till Perpetuity. Payables cant go on increasing, it will increase risk

Example

Risks of Negative IWC number

Tangible cost: Miss out on revenues

Implicit cost: Default risk

Pay more, COGS increases, Profitability drops

Note on FCFE: Potential Dividends

Economist report DOW 36,000

Earnings = Dividends Growth rate = Growth of Economy Discount rate = Rf!!!!!! Reason No 30 years period in which equity gave lesser returns than bond Reinvestment? Debt?

Estimating FCFE - Example

Earnings: 450 Mn New Debt ??

Depreciation: 50 Mn

IWC: 50 Mn

Therefore Cash inflow = 500 Mn

Capex: 200 Mn

Dealing with Debt

When principal repaid < New debt raised, there will be net Cash Inflow as a result of debt Assume a fixed proportion of investment is going to come from debt

If 40%

Then out of 250 Mn requirement, 100 comes from Debt

FCFE = 500 + 100 200 50 = 350 Mn

Example: Disney

Effect of Leverage?
What if you increased D/E? How will your answer change? Increase/Decrease? At 100% Debt funding, FCFE = Earnings!! Why not? Interest expenses increase Risk increases, so high Beta

Miller Modigliani Theorem

Proposition: Value does not change as leverage changes Too theoretical Depends on your current leverage

Estimating Growth Rate

3 Approaches
Look at the past usually a good starting point Look at analyst reports they must know more than I do How much does the company reinvest? How well does it reinvest?

Problem with Historical

Arithmetic v/s geometric?

Simple v/s Regression?

What if the company is making losses?

Next 5 years wont be same as last 5 years (base effect)

Motorola: Arithmetic v/s Geometric Growth Rates

Another problem
Year 1 earnings = -5% Year 2 earnings = 25% What is the growth rate? You cannot compute in this case Cyclical companies can be a nightmare!

Problems with 2nd Approach: Analyst forecasts

Tunnel Vision

Lemmingitis Factophobia

Stockholm Syndrome

Jekyll/Hide

Right Way Fundamental Growth Rates

Biggest source of Private information is company: BIAS There is far more public information than private in analyst s forecasts Herd mentality might land you in trouble. So will totally divergent views

3 Propositions

Fundamental Growth Rates

2 Ways of Growing

Reinvesting at same growth rate Same investment at higher ROI

5 Way of looking at growth

Growth in EPS Growth in Net Income Growth in EBIT and Fundamentals Growth in Operating Income Growth in Revenues

Growth in EPS
Normally applicable in stable state firms Not a lot changes You do not work at the top-line level (revenues) Directly start from EPS number, and estimate growth in EPS Remember: Growth = ROE * Reinvestment Rate

Growth in EPS

EPS growth can never exceed ROE! Limit to Reinvestment At 100% Reinvestment, Growth rate:
g = ROE*100% g = ROE

Example: ABN AMRO

Current ROE = 15.79% DPS = $1.13 EPS = $2.45 Reinvestment Ratio (RR) = 1 DPS/EPS RR = 54% If you assume ABN AMRO to maintain same DPS and ROE, g = 15.79 * 0.54 = 8.51%

Example: ABN AMRO

If you wanna grow ABN at 18% using this method: CANT ROE = 15.79%. Maximum growth = 15.79% If ROE on new investment is higher (for whatever reasons) say 17% g = 17% * 0.54 = 9.5%

Improving how well you reinvest

Improving ROE on existing investment: Bonus Growth Example 0% Reinvestment ROE = 10% in current year ROE expected is 20% next year Growth? My earnings of $100 will be $200. So growth rate = 100%!

Example: ABN AMRO

Generically, gEPS = ROEt+1*RR + (ROEt+1-ROEt)/ROEt If ABN s existing investments too gave an improved ROE of 17%, then ROEt = 15.79% ROEt+1 = 17% RR = 54% gEPS = 16.83% (Using the above formula)

Corporate Valuation: Discounted Cash Flow

-Ashish Chopra -September 10, 2010

Estimating Growth Rate

3 Approaches
Look at the past usually a good starting point Look at analyst reports they must know more than I do How much does the company reinvest? How well does it reinvest?

Problem with Historical

Arithmetic v/s geometric?

Simple v/s Regression?

What if the company is making losses?

Next 5 years wont be same as last 5 years (base effect)

Motorola: Arithmetic v/s Geometric Growth Rates

Another problem
Year 1 earnings = -5% Year 2 earnings = 25% What is the growth rate? You cannot compute in this case Cyclical companies can be a nightmare!

Problems with 2nd Approach: Analyst forecasts

Tunnel Vision

Lemmingitis Factophobia

Stockholm Syndrome

Jekyll/Hide

Right Way Fundamental Growth Rates

Biggest source of Private information is company: BIAS There is far more public information than private in analyst s forecasts Herd mentality might you in trouble. So will totally divergent views

3 Propositions

Growth MANTRA

Growth Rate = Return on Investment * Reinvestment Rate

Fundamental Growth Rates

Earnings this year:
Investment in Existing Projects: 1000 Return on Investment: 12% Therefore, Current Earnings: 1000 * 12% = 120

Earnings Next year:

Investment in new projects: 100 Return on investment (New Projects): 12% Return on investment (Existing Projects): 12% Therefore Earnings Next year: 1000*12% + 100*12% = 132

Growth next year:

132-120 = 12 Basically, growth = ROI (New Projects) * Reinvested capital Therefore, growth in earnings = 12% * 100 = 12

Fundamental Growth Rates

2 Ways of Growing

Reinvesting at same growth rate So how much you Reinvest? Same investment at higher ROI So how well you Reinvest?

5 Way of looking at growth

Growth in EPS Growth in Net Income Growth in EBIT and Fundamentals Growth in Operating Income Growth in Revenues

Growth in EPS
Normally applicable in stable state firms Not a lot changes You do not work at the top-line level (revenues) Directly start from EPS number, and estimate growth in EPS Remember: Growth = ROE * Reinvestment Rate

Growth in EPS

EPS growth can never exceed ROE! Limit to Reinvestment At 100% Reinvestment, Growth rate:
g = ROE*100% g = ROE

Example: ABN AMRO

Current ROE = 15.79% DPS = $1.13 EPS = $2.45 Reinvestment Ratio (RR) = 1 DPS/EPS RR = 54% If you assume ABN AMRO to maintain same DPS and ROE, g = 15.79 * 0.54 = 8.51%

Example: ABN AMRO

If you wanna grow ABN at 18% using this method: CANT ROE = 15.79%. Maximum growth = 15.79% If ROE on new investment is higher (for whatever reasons) say 17% g = 17% * 0.54 = 9.5%

Improving how well you reinvest

Improving ROE on existing investment: Bonus Growth Example 0% Reinvestment ROE = 10% in current year ROE expected is 20% next year Growth? My earnings of $100 will be $200. So growth rate = 100%!

Example: ABN AMRO

Generically, gEPS = ROEt+1*RR + (ROEt+1-ROEt)/ROEt If ABN s existing investments too gave an improved ROE of 17%, then ROEt = 15.79% ROEt+1 = 17% RR = 54% gEPS = 16.83% (Using the above formula)

ROE and Leverage

ROE = ROC + (D/E)[ROC + i(1-t)]

ROE = Return on Equity ROC = Return on Invested Capital D/E = Debt-Equity Ratio i = Cost of Debt (Pre-Tax)

Thus, in the above equation, if D/E Increases, ROE increases, so your growth rate will improve!!

Titan Example

Calculate ROE
ROC = 9.54% D/E = 1.91% COD = 10.125% (Post Tax)

Increase D/E to 3%, Calculate ROE Conclusion: Leverage helps ROE only if Return on Investment (Capital) > Cost of Debt

2. Growth in Net Income (NI)

In method 1, only way to grow is through growth in ROE and Retention Ratios. Hence a cap on growth Net income gives you a little more freedom You can issue more shares Thus maximum reinvestment no longer only 100%. It can be more

2. Growth in Net Income (NI)

Equity Reinvestment Rate:

[Net Capex + IWC] = Reinvestment [Net Capex + IWC] * [1 D/E] = Equity Reinvestment ([Net Capex + IWC] * [1 D/E])/Net Income = Equity Reinvestment Rate

Growth rate (Net Income) = ERR * ROE Growth in NI can be deceptive can come at a large issuance of shares

3. Growth in OI and Fundamentals

Reinvestment of not just equity, but all capital. So you look at Return on Capital
[Net Capex + IWC] = Reinvestment [Net Capex + IWC]/EBIT(1-t) = Reinvestment Rate (RR)

Growth Rate (g) = RR * ROC Question: Looking at the equation above, can there be growth without reinvestment?

3. Growth in OI and Fundamentals

Growth solely at the rate of inflation?

No, because of Replacement demand

If no Capex, no IWC, then 0% is the Maximum Growth that you can achieve

Example CISCO
CISCO
RR = 106.81% ROC = 34.07% Therefore, Expected Growth Rate = 36.39%

Motorola
RR = 52.99% ROC = 12.18% Therefore, Expected Growth Rate = 6.45%

High RR is good for CISCO as 34.07% is phenomenal ROC At ~12% ROC (Motorola) one can only dream of 53% growth like CISCO s Problem CISCO is 106.81% RR due to acquisitions. Sustainable?

4. OI Growth when ROC is changing

5. Estimating Growth when OI is -ve

Money loosing companies Start with revenues Target Margins Assuming the company becomes healthy, what is the margin likely to be then?
Estimate how much reinvestment is needed Complex. Use Sales/Capex Ratios

Young companies
Estimate size achieved by similar companies in 10 years See margins of stable peers Compute Sales/Cap RR in the industry

5. Estimating Growth when OI is -ve

If RR is negative, what are the implications? Growth rate will be negative. Need to work a lot with comparables

Closure in Valuation Terminal Value

Terminal Value (TV)

Liquidation method Use some multiple (EV/EBITDA, P/E etc) Stable Growth model

3 Methods

Using a multiple ..

. Is the definition of Relative Valuation Thus, you are driving maximum valuation in your DCF, from Relative Valuation! AVOID

Liquidation Most useful when assets are separable and marketable Hardly ever the case AVOID

Stable Growth Model

Implied assumption Company goes growing on at a stable rate No liquidation of the company ever Cant choose any number for this growth rate It would depend on the economy in which your company operates

Growth Rate for TV

Over the long run, no company in stable state should be able to grow faster than GDP Hence, GDP is the cap on TV growth rate Remember GDP is the maximum value your growth rate can take! What GDP rate to use? A good proxy is risk-free rate of return (Rf) Captures nominal return at no risk (adjusted for inflation)

Calculate TV

Geometric Progression gTV = Stable state growth rate dTV = Stable state discount rate Terminal Value:
(Expected Cash Flow Next Year)/(dTV gTV)

Considerations in TV
How long does your high growth period last? Statistically, companies manage to grow faster than industry average for 5 years. Hence, a safe assumption But not in all cases Can your terminal growth rate be negative? A better substitute to liquidation method

Considerations in TV

As your firm approaches stable growth:

Beta approaches 1 D/E comes closer to industry average Excess returns start to compress (competition) RR changes to gTV/ROE

Final Step Choosing the right Model

3 DCF models

Valuing Equity

Valuing Firm

DDM

FCFF

FCFE

Choice of Model

FCFE
Generally preferred Specially when the D/E is stable (in your assumption)

FCFF
When D/E is changing Adjusting Debt borrowings and repayments every year in cash flow is cumbersome Use FCFF and adjust your COC on changed D/E every year

Choice of Model
DDM
Extremely stable going concern (Rare) When you cannot estimate capex/working capital

Example: Financial Services

Capex: Regulatory Capital? WCap: Almost everything in Bank BS appears CA and CL D/E: 99x Leverage!

Getting company to stable growth

3 generic choices
Already in stable growth Large company growing at moderately high growth rate: 2 stage model
5 years of growth Then stable growth

Young company growing at 70% levels: 3 stage model

5 years of very high growth Next 5 years of moderate growth Then stable state

Tying up some Loose Ends

Loose ends in Valuation

Valuation of Cash? Should we discount Cash? How do we value cross holdings? Any other assets that should be valued? Should we punish companies that are difficult to value (Transparency issues) What should be counted as debt? (MV/BV/Contingent Liabilities/Minority Interest) What about distressed companies? What about Equity options?

Relative Valuation

3 Components

Finding Comparable Assets

Making sure the prices are comparable Controlling for the differences between the assets

Why so Popular?

Multiples are easier to sell In DCF every assumption is out there, open for critique DCF is contrarian ..

. To the interest of your job stability!!

Groups of Multiples
Earnings multiples
P/E, PEG, EV/EBIT, EV/EBITDA, EV/CF

Book Value multiples

P/B, EV/(BV of Assets), EV/(Replacement cost)

Revenue Multiples
Price/Sales, EV/Sales

Sector specific multiples

Cement Price/Ton

4 steps in understanding multiples

Define the Multiple
Ensure consistency

Describe the Multiple

Histogram

Analyze the multiple

Fundamentals that derive the value of the multiple

Apply the multiple

Find out how the valuations compare

Step 1: Define
Ensure Consistency
If numerator is an equity value, then denominator should also be an equity value If N is an operating/firm value, the so should D be

Example: P/E
N = Price (share price equity value) D = EPS (earnings to shareholder equity value)

EV/EBITDA
N = EV Firm level value D = EBITDA Firm level value

Price/EBITDA
SHOCKER!!

Step 1: Define
Is there something fundamentally wrong with using Price/EBITDA? Can you all think of something?

Step 2: Describe
Never done!! But all you need to do is create a histogram Statistics gyaan The histogram will not be symmetric
NOT A NORMAL DISTRIBUTION Skewed to the left

What does it imply?

Mean and Standard deviation do not describe the characteristics Mean is misleading

Hence Focus on Median

Step 2: Describe
People use average multiple explanations in the market to sell stock ideas and not median. Can you think why? (Hint The histogram will be skewed to the left)

Step 2: Describe
A problem You may often not have enough sample size for a particular multiple. The problem is not the number of companies, but the number of companies with a valid value for that multiple

Step 3: Fundamental Drivers

What would the P/E ratio depend upon? What ratios/values do I see to decide what P/E multiple should I give to this company? P/E depends on:
COE (or Beta) Growth Rate Payout Ratio

Step 3: Fundamental Drivers

2 companies, all else same but growth rates are 10% and 20%. Who gets higher P/E? How much higher?????

Step 4: Apply
Key question: What do you choose as similar companies?
Same sector Similar growth rates Similar risks Comparable companies as in the case of DCF

P/E MULTIPLE

P/E Ratio
Price Always Current Market Price (So pretty much fixed) EPS
Current (Recent Year) TTM (EPS of trailing 12 months) Forward PE (EPS of next 4 quarters) Forward PE (EPS of next fiscal) Primary/Diluted/Partially Diluted Before extraordinary items/After extraordinary items Accounting rules followed (options expensed or not? etc.)

P/E Multiple - Describe

Remember the basic tenets:

The histogram is skewed to the left Median lower than the average Never fall for the argument of average

Sample Distributon

P/E Multiple - Analyze

Simplest Derivation Use DDM Price0 = DPS1/(r gn) Divide by EPS on both sides P0/EPS0 = DPS1/[EPS0 * (r-gn)] P/E = [DPS0 * (1+gn)] /[EPS0 * (r-gn)] P/E = PR * (1+gn)/ (r-gn)

P/E Multiple - Analyze

But hardly any companies in stable state paying out all potential dividends Formula to extend it to 2 stage DDM

P/E Multiple - Analyze

So when will companies have higher P/E?

High Growth Rate (g) High Payout Ratio Low Risk ( r )

P/E Multiple - Analyze

High Payout Ratio implies higher P/E? But it should imply lower Reinvestment, hence lower growth? Hence lower P/E?

P/E Multiple - Analyze

Effect of interest rates? What would P/E multiple be more sensitive to? Lower interest rate of higher interest rate scenario?

P/E Multiple: Apply

Collect a sample of companies and their P/E multiple Identify a company or companies with lesser P/E Are these undervalued? Check with the fundamental drivers
Is there anything in the company s growth rate or ROE or Risk that it should deserve a lesser P/E?

What do you observe:

High growth, High Risk, Decent ROE!

P/E Multiple: Apply

What do you do? You need to know how much is the individual impact of growth rate, ROE and risk on P/E Go back to your age old regression!

Possible problems with regression Multi-collinearity

Risk and growth go hand in hand

Linear relationship assumption

This may not be true May be true today, may change over time

Rule of thumb for PE Peter Lynch

P/E < Growth Rate Stock is undervalued Obvious problems in this assumption:
No basis for believing that the stock is undervalued just because P/E < GR What if interest rates are high? At high IR, P/E will be low. Most stocks will be a BUY

PEG Ratio
Definition
P/E Expected growth rate

IDEA: To neutralize the growth effect Consistent ratio Do not double count growth
Use current P/E instead of forward P/E and expected growth rate

PEG Ratio

PEG Ratio
Growth still all over the PEG equation

Therefore, you have not adjusted for growth in a PEG ratio

That is, 2 companies with PEG ratio of 0.6 and 1 respectively, similar risks, does not imply that the 1st company is cheaper

PEG Ratio
When plotted v/s Risk (Cost of Equity): As r increases, PEG comes down!!! When plotted v/s growth rates: High PEG fir low growth rates Then decreases for higher growth rates The picks up again!

PEG Ratio Applying the multiple:

Regressing PEG v/s Growth and Risk will give u a scatter plot that makes no sense! That is because the relationship is not linear To make it linear, one option is to plot regression of logs of variables

PEG Ratio
Low growth companies may appear overvalued

Little reinvestment, high dividend and hence low growth

Variant: PEGY (Y = Dividend Yield)

PEGY = PE (GR + DY)

Relative P/E
Relative P/E = P/E of company P/E of Market

Valuing Toyota and comparing it with Volkswagon

Most useful when you are valuing companies across: Markets Time

Firm Value Multiples

EV/FCFF
Depends on:
Growth Rate WACC (Risk)

Never used in practice Compare:

EV/FCFF EV/EBIT EV/EBITDA

EV/EBITDA
Unheard of in the 1980 s Sprung into action as a multiple for acquisition valuation Good reasons:
More reference companies (+ve EBITDA) Comparable (depreciation may vary heavily among companies) Protects against leverage buyout effects Differently levered firms valued evenly

EV/EBITDA
EV = MCap + Debt Cash Why reduce Cash? What about Minority Interest?

EV/EBITDA
Rule of thumb: Anything less than 7x times EV/EBITDA is CHEAP!!! What is the average/median EV/EBITDA across market?

EV/EBITDA
Fundamental Drivers

EV/EBITDA

Fundamental Drivers: Tax Rate Depreciation Rate Growth Rate (in operating income) Reinvestment Rate

Book Value Multiples - Price

Book Value Shareholders equity Does not include preferred stock!! Price Book Ratio Variants:
P/B Value/Invested Capital Value/Book Capital

Book Value Multiples - Price

Can the book value be negative? Can your Invested capital be negative?

Book Value Multiples - Price

Fundamental Drivers:

Book Value Multiples - Price

Fundamental Drivers: Excess return over Risk (ROE v/s r) Growth Rate

Book Value Multiples - Price

Book Value Multiples - Price

P/B Widely used in valuing banks Reason
Books in a bank more close to reality than any other sector (Marked to Market) You don t play many games cook books in a bank

How do you differentiate between banks?

How good are their borrowers?
NPA s Bad Loans history

Ratio for turn-around stocks

Book Value Multiples - Value

Price/Sales
Internally inconsistent But no other option in the case of negative operating income Should you use EV/Sales or Price/Sales?

Price/Sales
Description: No longer a skewed histogram

Price/Sales
Fundamental Drivers: Growth firms

Price/Sales
Fundamental Drivers: Growth firms

Price/Sales
Depends on:
Net Margin Payout Ratio (ROE) Risk Growth Rate Companion Variable = Net Margin

EV/Sales

Companion Variable EBIT (1-t)

Determining Companion Variable

Take the denominator of your multiple Divide by the denominator: In case of Price multiple, PAT In case of EV multiple, EBIT (1-t) Apply:, Price/Sales, EV/Book Apply: P/E ?

EV/Sales
Determinants:
Growth Reinvestment Rates WACC

Choosing the right multiple

Your Options:
Take all multiples, calculate Simple Average Take all multiples, take a weighted average Choose any one multiple

Choosing the right multiple

At least take a weighted average not simple! How to assign the weights? More precise the multiple, higher the weight How do you know which multiple is more precise? Check out for that R2 in your regressions

Choosing the right multiple

Just pick one! Whichever gives you a value closest to you your DCF value! But prepare a good rationale as to why you chose that multiple for your company in your presentations It has some MARKS allocated!!

Choosing the right multiple

Generally look for what is the most intuitive multiple for your sector What the managers in your company and industry focus more on? ROE Book Value multiples Growth P/E Multiple Example Retail Industry in India?

Choosing the right multiple

Cyclical/Manufacturing P/E, Relative P/E Hi-tech, High growth P/E, PEG High Growth + Negative Earnings P/S, EV/S Heavy Infra EV/EBITDA Retailing P/S, EV/S

THE END.. Of DCF + RV

SAD DEMISE?

BRAND VALUATION

Giving a premium to a brand

Questions:
Should you add premium to a brand? How much premium do you give? Nestle? Hindustan Unilever? Which one gets a higher premium?

Giving a premium to a brand

What strengths does a brand give you?

Ability to charge a higher price, hence higher revenues Hence, better margins Hence better cash flows Better valuations

Giving a premium to a brand

So, to value a brand, figure out: Without this brand name, at what price can the same product be sold? How will the margins be in that case? How much cash flows, hence the value? Compare with the valuation you arrive today The difference is the value assigned to the brand

Giving a premium to a brand

Is it that simple? What are we assuming/ignoring? Any other competitive advantages than the brand How do you split up the differences?

Giving a premium to a brand

Value an Investment bank like Goldman Sachs? Networking gives it the brand Valuing a Sony? .If you do your DCF right, it should all be in there. Therefore do not add a brand value premium . Because it is double counting!

Valuing Private Companies

Valuing Private Companies

Differences to DCF: What model do you choose? What discount rate do you use? How do you estimate the cash flows? Most importantly, why are you valuing the company??

Valuing Private Companies

Reasons for valuing private companies: Tax purposes in the court of law Selling to another private company Selling to another public company Raising an IPO Hiving off an arm of a listed company

Valuing Private Companies

Cost of Equity (Beta) 3 choices: Comparable firms Beta Bottom up Accounting Beta (Change in earnings of co. divided by change in earnings of Nifty/Sensex) Any random value

Valuing Private Companies

Cost of Equity (Beta): Bottom up Need to unlever the Beta What debt/Equity do you use? There no market equity here. DO NOT USE Book debt/Equity Use industry average instead Or if you know company s targeted D/E

Valuing Private Companies

Cost of Equity (Beta): Remember Beta is un-diversifiable risk In a private transaction is there any risk diversified? Here you need to understand the reason for valuation

Valuing Private Companies

Estimating Cash Flows: Most companies have a shorter history Different accounting standards Intermingling personal and business expenses Need to separate salaries from dividends

Valuing Private Companies

Estimating Cash Flows: Adjust for personnel and operating expenses What are the true direct costs? Work out the cost of replacing the promoter

Valuing Private Companies

Adjusting for illiquidity Illiquidity is a problem But how much discount?? Based on:
growth rate business health business size What kind of assets you own

Valuing Private Companies

Adjusting for control premium Matters in both public and private companies What is the value today? How can you change the value? What is the probability that you can change the value?