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A Review of

VALUATION TECHNIQUES
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VALUATION TECHNIQUES
Dividend Discount Model (DDM) Method Discounted Cash Flow (DCF) Method Net Tangible Asset (NTA) Method Relative Valuation Methods

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DCF Method
General Formula
CF1 CF2 CF3 CF4 CFn ..... (1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) n

Value of asset =

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Key Elements of DCF Method

Discount rate, r Forecast periodic cashflows, CF1n Number of periods, n Terminal value

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DDM Method
- Two-Stage DDM
t=n

t=1

DPSt
(1+ ke)t

Pn
(1+ ke)n

where

Pn

DPSn+1
=

ke g n

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DEFINITIONS OF CASH FLOWS

Net income (after taxes) Dividends

Free Cash Flow to Equity (FCFE) Free Cash Flow to Firm (FCFF)
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FCFE
Net Income (after taxes) + Non-cash charges (Depn & Amortizn) - Capital expenditures - Changes in Net Working Capital + Net changes in long-term Debt = Free Cash Flow to Equity
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FCFF
Net Income (after taxes) + Non-cash charges (Depr. & Amortizn) - Capital expenditures - Changes in Net Working Capital + Interest expense (net of taxes) + Preferred dividends = Free Cash Flow to Firm
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How to derive FCFE from FCFF

FCFF Less Market value of all Outstanding Debts = FCFE

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Which discount rate (r) to use?

The discount rate of return is the Weighted Average Cost of Capital (WACC), which can be computed as follows:
ke WACC = E E+D kd (1 tc) + D E+D

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Key Elements of WACC

WACC ke kd tc E D E/(E+D) D/(E+D) = Weighted Average Cost of Capital = cost of equity = cost of debt = corporate tax rate = Total equities = Total debts = proportion of company funded by equity = proportion of company funded by debt

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Cost of Equity, ke
The Cost of Equity is usually derived from the Capital Asset Pricing Model (CAPM), which is as follows:-

Ke = Rf + (Rm Rf)

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Key Elements of CAPM

Rf is the rate of return on risk-free assets
such as Malaysian Government Securities (MGS)

Rm is the rate of return of the market

such as the long-term annualised return of stock market

(Rm Rf) is the market risk premium is the measure of volatility of the individual asset in relation to the overall market
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Relative Valuation Methods - Valuation Philosophy

Based upon how similar assets are currently priced in the market relative to a common variable such as earnings, cashflows, book value or sales

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Relative Valuation Methods

- General Application

Two components:-

Standardization of Prices Find Comparative Companies

How to Apply: After standardizing the share price of the company with the chosen variable, compare the standardized value with values of comparative companies
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How to Standardize Prices

Prices need to be standardized by converting prices into multiples of earnings, book values or sales such as: Price-Earnings (P/E) Multiple Price-to-Book (P/B) Multiple Price-Sales (P/S) Multiple
A Variant

Enterprise Value (EV) Multiple = Enterprise Value EBITDA

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Computation of P/E Multiple

Earnings are taken as net profit after minority interest and preference share dividends Earnings has to be maintainable Non-recurring one-off expense items have to be added back Non-recurring one-off revenue items have to be stripped off
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How to Find COMPARATIVE COMPANIES

Scan through universe of listed companies in same industry/sector Failing which, scan through universe of listed companies in industries/sectors that has strong linkages with the company to be valued Failing which, can adopt the broad market price multiple as a proxy (use with care)
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Points to Consider in Using Multiples

Ensure the multiple is defined consistently eg. based on forward or trailing earnings Remove outliers from basket of similar firms Drop non-meaningful negative multiples from the basket Merits of weighing the multiples by size of firms but beware of skewness of data
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Enterprise Value (EV) Multiple

- Valuation Philosophy
Look at a firm from a potential acquirer viewpoint as it takes debts into account Eliminates distorting effect of individual companys taxation, financing and accounting policies EV can be viewed as the theoretical takeover price as the acquirer has to assume the acquiree companys debts but would pocket its cash

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Computation of EV Multiple
Key Elements: Enterprise Value = Total Market Capitalization + Total Debts + Minority Interest + Preferred Shares - Cash EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization or Net Operating Income
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Computation of EV Multiple (Simplified)

Enterprise Value (or firm value) = Total equity value + Total Debts - Cash

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