INTRODUCTION TO VALUATION

CONCEPT OF VALUATION

❑ What is Valuation?
Valuation is the process of determining the estimated or intrinsic worth or value of an asset, investment, company, or
financial instrument. It involves assessing the economic value of the subject based on various factors, data, and
methodologies. Valuation is a critical aspect of finance and investment decision-making, as it helps individuals, businesses,
and investors understand the potential value and risks associated with their assets or investments.
 MYTHS:

❑ Myth 1: A valuation is an objective search for “true” value

• Truth 1.1: All valuations are biased. The only questions are how much and in which direction.
• Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and
how much you are paid.
❑ Myth 2.: A good valuation provides a precise estimate of value
• Truth 2.1: There are no precise valuations
• Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
❑ Myth 3: . The more quantitative a model, the better the valuation
• Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the
model.
• Truth 3.2: Simpler valuation models do much better than complex ones.
Where Do we Use These Valuation Techniques?
We are required to do valuations of the company or assets for various purposes. Couple of them are discussed below:

▪ Valuation of Target Company for the purpose of Merger or Acquisition

Mergers &
Acquisition
▪ Valuation of the company for the purpose of Initial Public Offering (IPO)
IPO

▪ Valuation to understand how much value we can unlock for the company by restructuring its
business activities, say spin off of non performing segment of the business.
Business
Restructuring

▪ Valuation of the company for the purpose of investment from private equity firm.
▪ With valuation only, we will be able to know how much stake we
Private Equity are required to dilute to PE firm for target investment amount in the company
Investment
 APPROACHES TO CORPORATE VALUATION

Corporate Valuation
Approaches

ECONOMIC PROFIT OTHER APPROACHES

INCOME OR EARNINGS
Relative Valuation: Uses different
Uses the future expected earnings to Uses the economic profit of a
types of market multiples. These are
measure the Free Cash Flow of the company in a given period and
either trading multiples or prevailing
company, to measure value. Value can be measures value of the company.
transaction multiples.
estimated either using firm cash flow or Under this approach, value is
equity cash flow and discounting it defined as the sum of the present Asset-based Valuation: Uses existing
appropriately. This method is known as the capital employed and the present assets as a base for valuation. Not
DCF method. value of the projected economic considered by many as an
profit for the future. independent method.
Earnings capitalisation method may also be
used as an alternative, though DCF Contingent claim valuation: Uses
methodology is more comprehensive. option pricing models in cash flow
based valuation to factor in
embedded real options.
 Assessment of Alternative Approaches to Value Measurement

❑ Though several approaches to valuation are available, the ones that are mainly used are the earnings approach based on
Discounted Cash Flow (DCF) analysis, relative valuation based on earnings multiples or market multiples and the asset-based
approach. Each of these approaches has its own characteristics which needs to be well understood since they determine the
appropriateness of a particular method in a given case.

❑ The income or earnings based approach often scores over the other methods such as asset-based methods (cost approach)
and relative valuation based on market multiples. This is because the cost approach does not consider some critical drivers of
value as the income approach.

❑ However, the income approach has several judgemental factors and assumptions to be made which make it quite subjective.
The use of relative valuation is tricky since it requires comparing an apple to an apple. Therefore, the valuation could be
misleading, if comparable data is not available for a particular business

❑ So, when business models are unique or comparable data is not available, the relative valuation approach would not be
appropriate.
Why does each valuation technique usually
give us such different results?
 Valuation Views
These techniques each provide us with insight into the views of different groups.

Comparable Trading Analysis Market participants move the stock

Looks at the valuation for similar peer prices for peer companies, so this
companies that are publicly traded. M arket
technique shows their view.
View

Precedent Transaction Analysis Previous buyers set acquisition

Looks at the acquisition prices for prices, so this technique shows
similar peer companies in recent Buyer
their collective view.
transactions. View

Discounted Cash Flow Analysis Builds a

You will build the DCF Model. If
model of the company to get the
you also select the inputs, then
present value of all future free cash flows. Your
this technique shows your view.
View
 DISCOUNTED CASH FLOW VALUATION

❑ The present value of the anticipated cash flows on an asset, as determined via discounted cash flow valuation, represents
the asset's value.

❑ Every asset has an intrinsic value that may be calculated based on its cash flow, growth, and risk characteristics.

❑ To utilise discounted cash flow valuation, you must:

• estimate the asset's life;
• estimate the cash flows that will occur during that life;
• estimate the discount rate that will be used to convert those cash flows into present value.

❑ Markets are assumed to make mistakes in pricing assets across time and are assumed to correct themselves over time, as
new information comes out about assets.
 ADVANTAGES OF DCF VALUATION

❑ Discounted cash flow valuation is the appropriate method to think about what you are getting when you acquire an asset
since excellent investors buy businesses rather than stocks.

❑ You are compelled by DCF valuation to consider the fundamental traits of the company and comprehend its operations. It
forces you to confront the assumptions you are making when you pay a specific price for an asset, if nothing else.
 DISADVANTAGES OF DCF VALUATION

❑ There is no assurance that anything will show up in an intrinsic valuation model as being undervalued or overvalued. Thus, it
is possible to find that every stock in a market is overvalued using a DCF valuation model. This can be a problem for:
• equity research analysts, whose responsibility is to follow industries and offer advice on the most undervalued and
overvalued companies in each of those industries.
• managers of stock portfolios, who must hold a majority (or almost a majority) of their assets in equities.

❑ It demands significantly more explicit inputs and information than other valuation methodologies because it aims to
estimate intrinsic value.
 IMPORTANT DATES

❑ Consider two important dates while using DCF

• The valuation date
• Cash flow timing

The Valuation Date Cash Flow Timing

These are the dates within each
This is the date we set & use for
year when cash flow occur
the valuation
We assume cash flow occur at the
All cash flow quantities will be
end of each year
adjusted to this date
 FIRM VS. EQUITY VALUATION (DCF)
Firm Valuation: Value the entire business

ASSETS LIABILITIES

Existing Investments Fixed claims on cash flows

generate cash flows today little or not in management
Assets in Debt
Includes long-lived (fixed) & fixed maturity
place
short-lived (working capital) Tax deductible
assets
Residual claims on cash flows
Equity significant role in management
Expected value that will be Growth
Perpetual lives
created by future investments Assets

Equity Valuation: Value just the equity claim in the business

 FIRM VALUATION (FCFF)

ASSETS LIABILITIES
Cash flows
considered are cash Assets in Place Debt
flows from assets,
Discount rate reflects the
prior to any debt
cost of raising both debt &
payments but after
equity financing in
firm has reinvested
proportion to their use
to create growth
assets Growth Assets Equity

Present value is value of the entire firm, & reflects the value of
all claims on the firm
 EQUITY VALUATION (FCFE)

ASSETS LIABILITIES
Cash flows
considered are cash Assets in Place Debt
flows from assets,
Discount rate reflects only
after debt payments
the cost of raising equity
& after making
financing
reinvestments
needed for future
growth Growth Assets Equity

Present value is value of just the equity claims on the firm

 Free cash flow to Free cash flow to
firm (FCFF) firm (FCFFE) Projected Dividend

Earnings Before Interests

FC F F Projected E P S
and Taxes (EBIT)

Taxes* on EBIT Interest x (1-Tax Rate*)

Projected Pay-out Ratio

Non Cash Charges and In growth declining phase

Net Change in Debt
Earnings gradually increase Pay-out
ratio to reach target pay- out
ratio in maturity stage

Capital Expenditure FCFE

Target pay-out ratio in
maturity stage =1-matured
growth/ROE at maturity
Change in Working Capital stage

FCFF Projected Dividend

 DCF STEPS

Step I Projection of free cash flows

Step II Calculation of discount rate; WACC or Ke depending upon which cash flows we are
discounting
Step III Calculation of Terminal value with

✓ Perpetual growth method

✓ Exit multiple approach

Step IV Discounting projected cash flows (calculated in Step I) and Terminal value (calculated in
step III)using discount rate (calculated in step II)
Step V DCF value =sum of PV of projected cash flows and PV of terminal value
 DCF VALUATION MODEL
Expected Growth
Firm: Growth in operating
Cash flows
earnings
Firm: Pre-debt cash flow
Equity: Growth in Net
Equity: After-debt cash flows
Income/EPS
Firm is in stable growth:
Grows at constant rate
forever

Terminal Value
Value CF 1 CF 2 CF 3 CF 4 CF 5 CF n
Firm: Value of firm Forever
Equity: Value of equity

Length of Period of High Growth

Discount Rate
Firm: Cost of capital
Equity: Cost of Equity
 FIRM VALUATION
Cash flow to Firm
EBIT (1-t) Firm is in stable growth:
- (Cap ex – Dep.) Grows at constant rate
- change in WC forever
Value of Operating =FCFF
Assets
+ Cash & Non-op Assets Terminal Value = FCFF n+1/(WACC-gn)
=Value of firm
- Value of Debt
-Minority Interest FCFF 1 FCFF 2 FCFF 3 FCFF 4 FCFF 5 FCFF n
=Value Of Equity Forever
Discount at WACC = Cost of equity*(E/(D+E)) + Cost of Debt*(D/(E+D)(1-t))
Cost of Equity
Risk-free Rate
Beta Risk Premium
- No default risk
- Measures market risk - Premium for average
- No reinvestment risk
risk investment
- In same company &
in same terms
 EQUITY VALUATION WITH DIVIDENDS
Expected Growth
Retention ratio*Return on
Dividends
equity
Net Income*Payout ratio = Firm is in stable growth:
Dividends Grows at constant rate
forever

Terminal Value = Dividend n+1/(ke-gn)

Value of Equity Div 1 Div 2 Div 3 Div 4 Div 5 Div n

Forever
Discount at cost of equity
Cost of Equity
Risk-free Rate
Beta Risk Premium
- No default risk
- Measures market risk - Premium for average
- No reinvestment risk
risk investment
- In same company &
in same terms
 EQUITY VALUATION WITH FCFE
Expected Growth
Retention ratio*Return on
equity
Cash flow to Equity Firm is in stable growth:
Grows at constant rate
forever

Terminal Value = FCFE n+1/(ke-gn)

Value of Equity FCFF 1 FCFF 2 FCFF 3 FCFF 4 FCFF 5 FCFF n

Forever
Discount at cost of equity
Cost of Equity
Risk-free Rate
Beta Risk Premium
- No default risk
- Measures market risk - Premium for average
- No reinvestment risk
risk investment
- In same company &
in same terms
 EXPLICIT PROJECTIONS

❑ Typically, in modeling scenarios, we often create explicit forecasts for a company's performance over a 5 to 10-year horizon.
This presupposes that the company will transition into a phase of stable growth during this timeframe. The reasoning behind
selecting this projection window of 5 to 10 years is grounded in the following assumptions:
• Observing the growth trajectories of publicly-traded firms, especially those with readily available historical data, reveals a
common trend. The majority of these companies tend to reach a point of growth saturation within the 5-10 year time
span.
• Sustaining rapid growth over an extended period becomes increasingly challenging for a company as it expands. With
growth, the company's overall size increases, making it progressively harder to achieve the same level of high growth as
when it was smaller. This phenomenon is often referred to as the "base effect," and it naturally leads to a slowdown in
growth over time.
• Unless a company possesses significant barriers to entry for potential competitors, intense competition can hinder the
continuation of sustained growth.
 PROJECTION PERIOD

❑ In certain situations, an extended projection period, which extends beyond the typical 10-year horizon, can be justified,
especially when evaluating a relatively young company. We can consider projecting a prolonged phase of robust growth if
there is substantial evidence supporting the company's ability to sustain such growth over an extended period.
❑ In such instances, it might not be suitable to confine our projections to the conventional 5-10 year range. Companies with
specific characteristics that make extended projections relevant include:
• Operating within a Niche Industry: Companies operating in specialized industries, where competition is limited and they
have a unique foothold, may warrant extended projections.
• Established and Proven Business Model: If a company possesses a well-established and validated business model, it may
have the potential for sustained growth beyond the usual time frame.
• Barriers to Entry: Companies facing significant obstacles to entry, whether due to advanced technology, stringent
regulatory requirements, or the capital-intensive nature of their industry, can justify longer projection periods.
❑ On the flip side, when dealing with companies that have already reached maturity or are rapidly approaching that stage,
projecting their performance over a lengthy 5-10 year period may not be necessary. In these cases, projecting several years
into the future becomes superfluous, and we can calculate the terminal value right from the outset (year 0).
❑ For companies on the cusp of maturity, it's more practical to restrict the projection period to a span of 3 to 5 years, while
carefully considering the company's growth prospects during this time frame. This approach aligns with the company's lifecycle
and provides a more accurate valuation.
WAYS OF ESTIMATING TERMINAL VALUE

Terminal Value

Stable Growth
Liquidation Multiples
Model (Gordon
Value Approach
Growth Model)

Technically sounded,
Most useful Easiest approach but requires that you
when assets are but makes the make judgements about
separable & valuation a when the firm will grow
marketable relative valuation at a stable rate which it
can sustain forever, &
the excess returns (if
any) that it will earn
during period
 GETTING TERMINAL VALUE RIGHT

❑ When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g) where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate

❑ The steady growth rate may be set lower but cannot be greater than the economic growth rate.
• If you assume that the economy is composed of high growth and stable growth firms, the growth rate of the latter will
probably be lower than the growth rate of the economy.
• The stable growth rate can be negative. The terminal value will be lower and you are assuming that your firm will
disappear over time.
• If you use nominal cash flows and discount rates, the growth rate should be nominal in the currency in which the valuation
is denominated.
 Important points

Question: Why is tax calculated on EBIT (earnings before interest and taxes) and not on PBT (profit before tax)?
Answer: The Free Cash Flow to Firm (FCFF) that we calculated earlier is discounted using the firm's weighted average cost of capital
(WACC), which combines the costs of both debt and equity. In the WACC calculation, the cost of debt is determined as the interest
rate multiplied by (1 - tax rate). This already takes into account the tax shield on interest expenses. Therefore, including the same tax
shield on interest in the FCFF calculation would result in double-counting this benefit.

Question: To avoid this double counting of the tax shield on interest, would it be acceptable to exclude the tax shield on interest in
the WACC calculation and include it only in the FCFF calculation?
Answer: No, it would not be advisable to do so. While this approach might seem mathematically correct, it is conceptually flawed in
both the FCFF and WACC calculations. FCFF represents the cash flow available for distribution to all the capital invested in the
business, and interest represents a debt claim on these cash flows, which is not deducted when calculating FCFF. Hence, the tax
shield on interest should be ignored in FCFF calculations. FCFF is often referred to as unlevered free cash flows because it remains
unaffected by the business's leverage. Considering the tax shield on interest would partially link your cash flows to interest expenses.
In the WACC calculation, using the gross cost of debt as Kd would also be incorrect. This is because the company benefits from tax
savings on interest costs, and the actual cost of debt should be Kd net of tax to accurately reflect the company's financial situation.

❑ Reinvestment in the Business = Add: Depreciation & Amortisation Exp.

Less: Capital Expenditure
Add/Less: Change in Working Capital
❑ Capital expenditure we incur in the business includes two parts
i) Maintenance capital expenditure, and
ii) Expansion capital expenditure,

❑ For maintenance capital expenditure, we regularly create provisions from earnings through D&A. Therefore capital
expenditure incurred to the extent of D&A provision doesn’t require any reinvestment of earnings in the business because
we have already created provision to replace existing asset by charging D&A to income statement. But capital expenditure
for expansion of business requires reinvestment of earnings in the business.

❑ Therefore while calculating reinvestment of earnings in the business, we net off D&A against total capital expenditure amount
to calculate net capital expenditure incurred on the expansion of the business. Adding investment in working capital through
change in working capital would result in total reinvestment in the business.
Question: Should stock-based compensation expenses (SBC) be added back while calculating FCFF, considering they are non-
cash expenses?
Answer:
• No, we should not add back stock-based compensation expenses unless we can also account for the dilution in the number of
shares that will occur due to future SBC expenses incurred by the company.
• When we include SBC in the calculation of projected FCFF, we are essentially assuming that, being a non-cash expense, it will
not negatively impact the company's cash flows, and therefore, it will have no effect on the discounted cash flow (DCF) value
of the company's shares. While this assumption is correct in the sense that SBC does not directly impact cash flow, it is
incorrect in the aspect of its impact on the DCF value of shares.
• Stock-based compensation expenses represent a business cost incurred by the company when it issues stock to its employees
in lieu of cash payments. Therefore, although SBC expenses are non-cash and do not directly affect cash flows, they lead to
future dilution of shares.
• The final output of the DCF calculation is as follows: DCF value per share = DCF value of Equity / Diluted number of shares
outstanding
• Adding back SBC expenses does increase the DCF value of equity, but it also results in a higher number of shares in the
denominator of the equation, effectively offsetting the increase in the cash value in the numerator.
• In practice, it is challenging to accurately adjust the denominator (i.e., the diluted number of shares) to account for the dilution
caused by future SBC expenses issued to employees. Therefore, by not adding SBC expenses to FCFF, we balance the effect of
not incorporating the dilution caused by these future SBC expenses into our valuation.
 CONSOLIDATED & STANDALONE RESULTS

❑ Consolidated Results -
• Consolidated statements includes the financial data from a parent company and its subsidiaries.
• When there is 50% or more ownership/investment, that company will show standalone and consolidated both data.
• If both parent company and subsidiary are operating in the same industry, consolidated results are used for valuation
purposes.

❑ Standalone Results -
• Financial statements that includes financial performance and position of a company without taking into account the
effects of any subsidiary companies.
• When there is less than 50% of investment of a company into subsidiary, that company shows that as an investment in
the balance sheet on assets side.
• If both parent company and subsidiary are operating in different industries(in case of more than 50% of investment),
standalone results of both are used.
 MINORITY INTEREST

❑ Minority interest also referred to as non-controlling interest, means an ownership share in a subsidiary company that is not
held by the parent company. This occurs when parent company hold more than 50% of voting shares but not all of the shares
of a subsidiary.
❑ It is a percentage of subsidiary’s stock that the parent firm does not possess.
❑ The minority interest needs to be taken into account when valuing a firm.
❑ There are few reasons of why do we add minority interest in the calculation of enterprise value-
• According to accounting regulations, if a company holds over 50% equity in another company, than that company is
considered a subsidiary of the former.
• The parent company is obligated to incorporate 100% of the subsidiary’s assets, liabilities, revenue, expenses and cash
flow into its financial statements.
• This implies that all financial metrics at the company level, such as Sales, EBIT, EBITDA, NOPAT, and FCFF, for the parent
company, encompass 100% of the corresponding figures from the subsidiary.
 Example of Consolidated Income Statement

Holding Co. Subsidiary Co. Consolidated

(in $ million) H S 100% of H + 100% of S
Revenue 700 350 1050
Less Operating Expenses 420 170 590
EBIT 280 180 460 100% of H
Less Interest Exp 40 15 55 +
Less Tax Exp 60 20 80 100% of S
Net Income 180 140 320
Less Minority Share in Net Income - 14
Net Income available to Common 306
Shareholders of Holding Co.
Appropriation of Net Income
Minority 10% S
Holding’s 100% H + 90% S

❑ In this example we can see line by line item consolidation of Income Statement. At the bottom, share of minority interest from
consolidated net income has been adjusted to calculate Net Income attributable to common shareholders of the holding
company.
❑ In this, minority’s claim on consolidated net income is equal to 10% of net income of Subsidiary Co (S) and the balance is
available to the shareholders of holding company.
 Example of Consolidated Balance Sheet

Source of Fund Holding Subsidiary Consolidated Application of Holding Subsidiary Consolidated

H S H+S Fund H S H+S
Equity 1,800 630 1,800 Long Term Assets 1,373 627 2,000
Minority Interest - - 63 Current Assets 400 153 553
Total Debt 420 80 500 Investment in 567 - -
subsidiary
Creditors 120 70 190

Total 2,340 780 2,553 Total 2,340 780 2,553

In the line by line item consolidation of Balance Sheet

❑ On the assets side of balance sheet, we can see that holding Co’s 567 million dollars of investment in subsidiary co [which
represents 90% of Equity of Subsidiary Co] is eliminated in consolidated balance sheet.
❑ To counteract this, on liability side, 90% Equity of Subsidiary co has been eliminated. Balance 10% Equity of Subsidiary company
not owned by holding co is shown as minority interest (10% of $630 mn = $63 mn)
❑ All other items are added on 100% basis in consolidated balance sheet (say long term assets, Current Assets, Total Debt,
and Creditors)
THANK YOU