Valuation

ValuationValuation

Date: 9 July 2006Prepared: Best Practices Team

OVERVIEW OF SHAREHOLDER VALUE OVERVIEW OF SHAREHOLDER VALUE CREATIONCREATION

InvestmentDecisions

OperatingDecisions

FinancingDecisions

Working capital; facilities;Programs

Price, volumeand cost trade-offs;Cost effectiveness

Debt, equityleveragepayout

Life, cycles;competition

Net Cash Flow from Operations

Discount rate

Cost of Capital Capital markets

Shareholdervalue

Dividends Capital gains

The manager The investor

What is Value?What is Value?

Value as a term has many meanings and is used to indicate actual, appraised, book, break-up, carrying, real, reproductive, depreciated, fair, face, fair market, going concern, insurable, intangible, intrinsic, liquidating, market, residual, sound and true value.

Our View of ValueOur View of Value

In the context of a firm, value commonly refers to either the value of the assets (book, market, or liquidation) or the value of an income stream (dividends, earnings, cash flow). The value of a income stream (cash flows) is a rationally determined and economic estimate of future earning potential of the firm.

Why value value?Why value value?

DCF is the best metric for corporate performanceShareholders maximize their own claims, simultaneously maximize everyone else’s claims.Corporate failure; capital flows away

Shortcomings of Accounting NumbersShortcomings of Accounting Numbers

EarningsAlternative methods of accounting may be employedInvestment requirements are excludedTime value of money is ignored

ROIROE

Impact of Accounting PoliciesImpact of Accounting Policies

Assumed no tax, no interest

Policy A Policy B Years 1 2 1 2

PBDIT 400 600 400 600 Depn. 200 200 400 100 PBIT 200 400 0 500 Cash flow 400 600 400 600

Impact of Time Value of MoneyImpact of Time Value of Money

Case 1Sales 200Optg. Exp. 170PBIT 30Tax 12PAT 18Value = 18/0.12 = 150


Case 2Sales 220Optg. Exp. 187PBIT 33Tax 13.20PAT 19.8Value = 19.8/0.12 = 165 - 15 (Inv) = 150Earning Up; Value constant


Case 3Sales 240Optg. Exp. 206PBIT 34Tax 13.60PAT 20.4Value = 20.4/0.12 = 170 - 30 (Inv) = 140Earning Up; Value Down

Approaches to ValuationApproaches to Valuation

Models of ValuationModels of Valuation

F irm

D ivid en d sF C F to E q u ity

E q u ity

C la im h o ld er

S tead y S ta teTwo S tag eTh ree S tag e

G rowth P a tte rn

D C F M od e ls

F u n d am en ta lC om p arab le F irm sR eg res s ion

A p p roac h

P /E R a tiosP /B V R a tioP /S a les R atio

M u lt ip les

R e la t ive V a lu ation M od e ls

E q u ityN a tu ra l R es ou rc eP rod u c t

O p tion P ric in g M od e ls

V a lu a tion M od e ls

Some statements people make Some statements people make about Valuationabout Valuation

True or False? Why?Valuation is objectiveA well researched and well-done valuation is timelessA good valuation provides a precise estimate of valueThe more quantitative the model, the better is the valuation

Some statements people make about Some statements people make about Valuation (contd…)Valuation (contd…)

The market is generally wrongThe product of valuation -- value -- is what matters; the process of valuation is not important

DISCOUNTED CASH FLOW APPROACHDISCOUNTED CASH FLOW APPROACH

Explicit forecast period Continuing value period

nnn

kCV

kCF

kCF

kCF

)1()1()1()1(Value 2

21

STEPS IN A DCF VALUATIONSTEPS IN A DCF VALUATION

Forecasting free cash flowEstimating the cost of capitalEstimate the continuing valueCalculating and interpreting results

Free cash flowFree cash flow

Total after tax cash flow generated by the company that is available to all providers of capitalFree cash flow is generally not affected by the company’s capital structure

Free Cash Flow CalculationsFree Cash Flow Calculations

EBITLess Tax on EBIT

Gives Net Operating Profit less adjusted taxes (NOPLAT)

Add DepreciationGives Gross Cash Flow

Free Cash Flow CalculationsFree Cash Flow Calculations

Estimated Gross investmentCapital ExpendituresInvestment in working capitalincrease in other assetsInvestment in goodwill

Gross cash flow less Gross investmentGives free cash flow to the firm

Free cash flow from other sideFree cash flow from other side

Change in excess marketable securitiesLess: after tax-interest incomeAdd: decrease in debtAdd: after tax interest expenseAdd: dividends

Gives Total financial flow

Thumb ruleThumb rule

Free cash flow = Total financial flowContinuing value forecast

Cash Flow EstimationCash Flow Estimation

2003 2004

EBIT 1430 1480

Add: Goodwill Amortization

20 20

Adjusted EBIT 1450 1500

* Provision for tax 495 4276

- Tax shield on interest income

7 7

+ Tax shield on interest expense

213 181

+ Change in Deferred tax

20 100

Tax on EBIT 681 500

Cash Flow EstimationCash Flow Estimation

2003 2004

+ Depreciation 387 400

Gross Cash Flow 1156 1400

+/- Change in NWC -123 -150

- Capex 587 600

-Change in Investment in OA

30 50

Total Capex +NWC -740 -800

Net Cash Flow 416 600

STEPS IN A DCF VALUATIONSTEPS IN A DCF VALUATION

Forecasting free cash flowIdentify components of free cash flowDevelop integrated historical perspectiveDetermine forecast assumptions and scenariosCalculate and evaluate the forecast

Developing integrated historical perspectiveDeveloping integrated historical perspective

Analysing historical free cash flow statements, supported by Income Statements and Balance Sheets of previous 5 to 10 yearsAnalysing the rate of return on invested capital over historical periodAnalysing the historical investment rate and its implications

cont.cont.

Drawing a conclusion about the sustainability of the company’s rate of return in excess of WACC

Determine forecast assumptions and Determine forecast assumptions and ScenariosScenarios

Determine the overall structure of the forecastDevelop relevant scenariosDeveloping a point of view about a forecast for each variableDeciding on the length of forecast

A StoryA Story

Demand is increasingly rapidly because of changing demographics, yet prices will remain stable because of the competitive structure of the industry. Given the company’s competitive position, it should be able to increase its market share somewhat, although profitability will remain constant.

ForecastForecast

Build the revenue forecast. This should be based on volume growth and price changes.Forecast operational items such as operating costs, working capital, PP&E by linking them to revenues or volumes.Project non-operating itemsProject the equity accounts. Equity should be equal to last year’s equity plus net income and new share issues less dividends and share repurchases.

ForecastForecast

Use the cash and/or debt accounts to balance the cash flows and balance sheetCalculate the ROIC tree and key ratios to pull elements together and check for consistency

Consistency and AlignmentConsistency and Alignment

Is the company’s performance on the value drivers consistent the company’s economics and industry competitive dynamics?Is the revenue growth consistent with the industry growth? If the company’s revenue is growing faster than the industry’s, which competitors are losing share. Will they retaliate? Does the company have the resources to mange the rate of growth?


Is the return on invested capital consistent with the industry’s competitive structure? If the entry barriers are coming down, shouldn’t expected returns decline? If the customers are becoming more powerful, will margins decline? Conversely, if the company’s position in the industry is becoming much stronger,should you expect returns to increase? How will the returns look relative to competition?


How will technology affect the returns? Will they affect risk?Can the company manage all the investments it is undertaking?

STEPS IN A DCF VALUATION …contdSTEPS IN A DCF VALUATION …contd

Estimating the cost of capitalDevelop target market value weightsEstimate the cost of equityEstimate the cost of non equity finance

COST OF CAPITALCOST OF CAPITAL

WACCWACC

k = ke * we + kd * (1-t) * wd

Target WeightsTarget Weights

Why target weights rather than year-to-year weights?

“Lumpiness” of financingSolves problem of circularity

Target Weights--How do I take care of:Target Weights--How do I take care of:

Debt financingStraight debtVariable rate debtLeasesOption featuresSwapsForeign currency obligations


Equity linked/hybrid Warrants and ESOsConvertible securities


Equity


Preferred

Cost of EquityCost of Equity

Gordon’s (Dividend Discount) ModelCapital Asset Pricing Model

Gordon’s ModelGordon’s Model

kDP

ge 1

0

Value of Stcok and Expected Growth

0

50

100

150

200

250

300

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Expected Growth Rate

Stoc

k Va

lue

Measuring GrowthMeasuring Growth

Analysts’ ForecastHistorical Time Series ApproachSustainable Growth Model

Analysts Forecast Analysts Forecast

Specialised services like ValueLine provide growth estimatesOwn estimates

Historical Time Series ApproachHistorical Time Series Approach

Arithmetic or geometric growth ratesRegression

Negative earningsNegative earnings

Percentage change in EPS = (EPSt-EPSt-1)/Max(EPSt, EPSt-1)

Or(EPSt-EPSt-1)/| EPSt-1|

Sustainable Growth ModelSustainable Growth Model

g = (plowback ratio) * (return on equity)

or

g = (plowback ratio) * (ROA + D/E*(ROA-i(1-t)))


g = (plowback ratio) * (ROA + D/E*(ROA-i(1-t)))

This implies that:ROE = (ROA + D/E*(ROA-i(1-t)))How?


Let’s define:ROA = [Net Income (NI) + Interest(I)*(1-t)]/

BV of assetsD/E = BV of debt/BV of assetsi = Interest expense on debt/BV of debtT= tax rate on ordinary income


Now, by substitution:ROA + D/E*(ROA-i*(1-t)) =[NI+I*(1-t)]/ (D+E) + D/E *{[NI+I*(1-t)]/ (D+E) –

I(1-t)/D }On simplification this term equalsNI/E or ROE

Value of past growthValue of past growth

Variability

Size of firmCyclicality in economy

1

)(1

n

ggn

tt

t

Value of past growthValue of past growth

Change in fundamentalsBusiness mix, Project choice, Capital structure, dividend policy, market forces, government regulations

Quality of earnings

Information used by analysts in making Information used by analysts in making forecastsforecasts

Firm specific public informationMacroeconomic factorsInformation revealed by competitors regarding future projectsPrivate information about firmsPublic information other than earnings

Individual Product line forecastIndividual Product line forecast

)])1([( tiEDbg jtjtjtjtjt

j linepdt for year t in rategrowth jtgj linepdt for year t in margin profit jt

j linepdt for year t in over asset turnjt

Other terms have usual meanings

k R E R Re f m f ( ( ) )

CAPITAL ASSET PRICING MODEL

CAPITAL ASSET PRICING MODEL CAPITAL ASSET PRICING MODEL

Key issues:Risk-free rateRisk premium

Arithmetic mean vs geometric meanBeta estimation issue

Choice of estimation periodChoice of return intervalChoice of market indexTendency to regress to oneAccuracy measurement

Means ControversyMeans Controversy

Suppose you bought a share for Rs 100. Next year the price of the share went up to Rs. 200 and in the subsequent year fell down to Rs. 100. What is your rate of return?Arithmetic return = [+100% +(-)50%]/2 = 25%Geometric return = [100/100](1/2) –1 = 0%


100

200

400

50

25

100

Prob. of up or down is 0.5Div=0


100

200

400 × 0.25 =100

50

25 × 0.25 = 6.25

100 × 0.50 = 50

Expected Price = 156.25This is same as 100×(1.25) ×(1.25) = 156.25

Adjustment for tendency to regress to oneAdjustment for tendency to regress to one

Method: One-third of distance to goal lineAtulya’s beta is 1.48Adjustment |(Raw beta –1)|/3Thus adjusted beta = 1.48 – [|(1.48-1)|/3] = 1.32If Meghana’s beta is 0.52. Then adjusted beta is?

Adjustment for tendency to regress to oneAdjustment for tendency to regress to one

Method: One-third of distance to goal lineMeghana’s beta is 0.52Adjustment |(Raw beta –1)|/3Thus adjusted beta = 0.52 + [|(0.52-1)|/3] = 0.68

Precision weighted peer group betaPrecision weighted peer group betaCompany D/V

MV Basis

MV of Equity

Est. Beta

Std. Err. Of beta

A 0.25 200 1.20 0.35

B 0.00 1150 0.80 0.20

C 0.14 850 0.85 0.25

D 0.36 500 0.75 0.46

Tax rate is 20%

Precision weighted peer group betaPrecision weighted peer group beta

Company

Unleverd beta

Precision of beta

Precision weight

Weight* Beta(UL)

A 0.947 8.1632653 0.151 0.143

B 0.800 25 0.464 0.371

C 0.752 16 0.297 0.223

D 0.517 4.7258929 0.88 0.045

Average = 0.782

Cost of DebtCost of Debt

Cost of debt is not the coupon rateCost of debt is the yield to maturity

Yield to Maturity (YTM)Yield to Maturity (YTM)

is that discount rate that makes the PV of the promised future cash flows equal to the current market price of the bond (IRR)the rate of return to an investor if she holds the bonds to maturity and if the coupons are reinvested at the YTM

YTM computationYTM computation

Pr( ) ( )

iceCoupon

rFaceValue Coupon

rii

n

1 1

Cost of Capital to GOICost of Capital to GOI

Source ofFunds

Amt(Rs. Crs.)

CostAssigned

WeightedCost

Taxation 4044 10 40440PSESurplus

1431 10 14310

Loans,SmallSavingsand Debt

6538 8 39228

ExternalAssistance

2087 4 8348

Deficitfinancing

2060 15 30900

Total 16160 133226

Weighted Cost = 133226/16160 = 8.24% (approx.)


Estimate the continuing valueDetermine the relationship between continuing value and DCFDecide forecast horizonDiscount to the present


Estimate the continuing valueSelect appropriate techniqueSelect forecast horizonEstimate parametersDiscount to present

Deciding on the length of forecastDeciding on the length of forecast

Explicit forecast periodContinuing value forecast

STEPS IN A DCF VALUATION …contd STEPS IN A DCF VALUATION …contd

Calculating and interpreting resultsDevelop and test resultsIntegrate results within decision context


TestsIs th result consistent with the value drivers implicit in forecast?Resulting value vs Market value?Do any results require special explanations?Are the financial aspects achievable and desirable?


InterpretClearly identify value drivers and key assumptionsHow much the variables can change without changing decisionsLikelihood of changes in key assumptions

Environment, competitive structure, internal competenceDevelop alternative scenarios

Final pointsFinal points

Avoid short-cutsAvoid hockey sticksBe realistic about synergiesOff Balance sheet items

Thank youThank you

Valuation

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