bav 2011 visit ii ppt

8/3/2019 Bav 2011 Visit II Ppt

http://slidepdf.com/reader/full/bav-2011-visit-ii-ppt 1/36

Apr-12 Deepak Kapur 1

Business Analysis and Valuation

IIM Indore

Term V – 2011

Deepak Kapur

[email protected]




Value Drivers

and

Valuation Models




Value Creation

• Accounting Profit has no meaning in valuation – it isEconomic Profit that matters

• What Ultimately matters is the relationship between ROIC

and WACC

• Sometimes one may have to sacrifice a % of ROIC to get

more absolute ROIC (the margin Vs volume business

decision)




Fundamental Model

• For a Company with constant rate of growth of Free Cash Flow(FCF)• The formula below is also known as the value driver relationship,

because it shows the links between the various value drivers and the

value of future cash flows

gWACC

)RONIC

g(1*NOPLAT

gWACC

IR)(1*NOPLAT

)g)(1*FCFFCFwhereperpetuitygrowingforformulaPVtheis(this gWACC

FCFValue

1t

1t

t1t

1t




In other words..

VALUE=f (ROIC, WACC and GROWTH)

Therefore is valuation whimsical?

A i




Approaches to ValuationParameter Discounted

Valuation Models

Relative Contingent

Claim

Asset Value

Basis Intrinsic Value = PV of

CF’s or Economic Profits

Market Price Based on Option

Valuation Models

Assets in hand

Inputs Life, cash flow or

Economic Profits and risk

of asset

Price of Comparable Volatility, underlying

asset value etc.

Liquidation

Value/Reproduc

tion Cost

Inefficiency is Across time Across market Underestimation Due to

illiquidity

Advantages Fundamental approach,helps understand

underlying characteristics

Lesser inputs, tends toreflect market moods, can

find several undervalued

and overvalued securities,

for analysts who are judged

on relative basis

Helps value assetswhich otherwise

cannot be valued

Downside verylimited and

value known

with more

certainty

Disadvantages many inputs, subject to

manipulation, possible tofind entire universe of

stocks overvalued

entire market valuation

itself could be high; makesimplicit assumptions about

fundamentals

Limited use, lack of

inputs in most cases

Ignores future

potential

Suited for Stable, positive cash flow

business, long term

investors or influential

investors

Securities with large

number of comparable,

investors with short term

horizon or targeting relative

performance.

Assets with option

characteristics -

patents, rights,

equity in troubled

firms

Companies with

long term

history of losses,

investors

looking for asset

stripping


http://slidepdf.com/reader/full/bav-2011-visit-ii-ppt 7/36Apr-12 Deepak Kapur 7

Themes on Discounted Valuation Models

2+8=10

4+6=10

6=10-4



Terminology

Conventions Vary Book to Book. So essential to understand concept.

• Invested Capital (IC) Capital required for the operations

• Operating Profit Operating Revenues – Cost of Revenues

• NOPLAT Operating profit less operating taxes

( NOPLAT = EBIT(1-t) )

• ROIC NOPLAT/IC (either starting capital or average capital is used – for purpose

of this course we will use starting, i.e. opening IC))

• Investment Rate (IR) Net Investment /NOPLAT• Net Investment ICt+1 - ICt

• Growth in NOPLAT g = ROIC(incremental)*IR

• Free Cash Flow (FCF) NOPLAT – Net Investment



Terminology

Economic

Profit

The excess earned on the entire operating capital

over the cost of capital. Similar to EVA for firm.

Economic Profitt = ICt-1* (ROICt – WACCt)

ResidualEarnings

The excess earned on the Book Value over the Cost of Equity. Similar to EVA for Equity.

Residual Earningst = BVt-1*(RoE-CoE)



Frameworks for Discounted Valuation Models

Model What is

Valued

Discount

Rate

Basis What to

Discount

Enterprise DCF

(FCFFM)

Entire Firm WACC Cash Flows (CFs) Operating CFs

Equity DCF

(FCFEM)

Equity Levered

CoE

Cash Flows CFs to Equity

Economic Profit

(EPM)

Entire Firm WACC Accrual Accounting Economic Profit

Residual Earnings

(REM)

Equity Levered

CoE

Accrual Accounting Residual

Earnings

Dividend Discount(DDM)

Equity LeveredCoE

Cash Flows Dividends

Adjusted Present

Value (APVM)

Entire Firm Unlevered

CoE

Cash Flows Operating CFs



Frameworks for Discounted Valuation Models

Model When is it useful

Enterprise DCF (FCFFM) Works best for projects, units of companies which manage

their D/E to a target level

Equity DCF (FCFEM) Because operating and financing cash flows are mixed it can

lead to errors and difficult to implement. Useful for banks /

debt free companies

Economic Profit (EPM) Explicitly highlights when a firm creates value.

Residual Earnings (REM) Shows link between book value and equity value. Useful

where book value captures the assets creating value / useful

for financial companies. (recall EVA?)

Dividend Discount (DDM) Useful for mature firms with very high payout ratios

Adjusted Present Value

(APVM)

For firms where capital structure is changing drastically



Discounted Cash Flow Based Valuation Models

APV = PV of FCFF + PV of tax shields – PV of bankruptcy cost =

FCFF (for FCFF use unlevered CoE as discount rate / for tax shields

its cost of debt or unlevered CoE)

APV (MM

Theorem)

DDM

FCFE

FCFF

nt

t t

t

CoE

FCFE Value Equity

1 )1(

nt

t t

t

CoE

Dive EquityValu

1 )1(

All Models (other than DDM) will give the same value. Equivalence will hold IFF you makeconsistent assumptions

nt

t t

t

WACC FCFF FirmValue

1 )1(



Interest Tax Shield

• Enterprise DCF and APV give the same value but only differ inthe way they calculate the PV of interest tax shields

• Where in Enterprise DCF are we accounting for the interest tax

shield?



Discounted Accounting Based Valuation Models

Accrual Accounting Models Should give same value at Cash Flow models if assumptions areconsistent

nt

t t

t t t

WACC

WACC ROIC IC IC FirmValue

01

11

0)1(

)(

Residual

Earnings

Model

DiscountedEconomic

Profit Value

nt

t t

t t t

CoE

CoE ROE BV BV e EquityValu

01

11

0)1(

)(



DCF or Economic Profit Model?

00

0

0

0

1t

1t

1t

ICgWACC

WACCROICIC

gWACC

-WACCWACCROICIC

gWACC

ROICIC

gWACC

)ROIC

g(1*(ROIC)IC

gWACC

)ROIC

g(1*NOPLAT

gWACC

IR)(1*NOPLAT

gWACCFCFValue

g

g



Estimating Discount Rates



DCF - Discount Rates

• Valuation can be very sensitive to discount rates – Should reflect riskiness and type of cash flows

– Should be in same currency and nominal or real terms as CF’s

• Risk and return models in finance assume that it is the non-

diversifiable risk that must be rewarded but not diversifiablerisk

• Cost of Equity is an implicit cost. Different investors – different riskiness view on the same asset

• Cost of Debt should incorporate the default premium overrisk free debt



DCF - Discount Rates - CoE

• Usual Approach to CoE - CAPM: – Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf )

• (E(Rm) - Rf ) – Risk Premium

• Rf = Risk free rate

• E(Rm) = Expected Return on the Market Index (Diversified Portfolio) – usually

calculated from standard deviation of the risk premium.

• Typically

– beta is measured by regressing stock returns against market

returns

– For risk free rate both short and long term rates are used

– Historical risk premiums are used



DCF – Risk Free Rate

• Risk Free1. No Default Risk

2. No Reinvestment Risk

• Problem with using Short Term Bond Rate?

• Is the GoI long term bond a risk free investment?• What tenure bonds to use for risk free rate?

• The risk free rate chosen depends not upon ‘where’ the asset is

located but on the currency used in valuation – consistency

principle• Risk free rate across countries should only reflect the inflation

differences

• Measuring Risk Free rate when no default free entity exists!!!!



DCF – Risk Premiums

• Measuring Historical Risk Premiums• Problem with historical risk premiums

– Data tenure

– Premium over which risk free rate?

– Arithmetic average or geometric average?

• What if you are valuing an international company?

– This may require to first measure other country risk premium

and then the company specific risk premium• What if the company derives significant revenues from

other geographies?



DCF – Implied Risk Premiums

• Second Approach - Implied Equity Risk Premiums: – Derived from valuing the index

• Use a valuation model to estimate discount rate given growth estimates

• Subtract risk free rate to get to market risk premium

– Has the advantage that it can be updated as often – Reflects forward looking risk premium which is more

consistent with our need of valuing the future and not past

– Implied risk premiums fall when indices increase, whereas

historical risk premiums would should an increase.



Nifty - Implied Equity Risk Premium

growth rate growth rate

Model

Implieddiscountrate (riskfree + riskpremium)

year1-5

terminal

ImpliedDiscountrate

year1-3

year4-6

year7-9

terminal

DDM 8.19% 16% 6% 8.45% 16% 12% 8% 6%

FCFE 13.15% 16% 6% 12.40% 16% 12% 8% 6%



Implied Risk Premiums

• Assume that the index jumps 10% today and that nothing elsechanges. What will happen to the implied equity risk premium? – Implied equity risk premium will increase

– Implied equity risk premium will decrease

• Assume that the earnings jump 10% today and that nothing elsechanges. What will happen to the implied equity risk premium? – Implied equity risk premium will increase

– Implied equity risk premium will decrease

• Assume that the risk free rate increases to 10% today and thatnothing else changes. What will happen to the implied equity riskpremium?

– Implied equity risk premium will increase – Implied equity risk premium will decrease




Source: Aswath

Damodaran




Effect of Changing Tax Rate on Dividends

• Example: – Q. Currently Dividends are tax free in hand of investors and

short term gains at 10%. The Dividend yield is 1.4% and

capital gains (i.e. index returns) are 7.1%. What if a tax is

imposed – 30% on dividends and short term gains? – A. Investors would continue to expect the same returns post

tax. Expected Return pretax was about 8.5% (Div Yield 1.4%

+ Cap Gains of 7.1%)

• Current Expected Return Post tax = 1.4% + 7.1 (1-0.1)% = 7.8%

• After tax law change = 1.4 (1-.3) + x*(1-.3)% = 7.8%




DCF - Issues with Discount Rates - Beta

• Beta - Supposed to measure relative risk of the stock• Conventional Approach

– Beta is equal to slope of regression line of stock returns vs

market returns

– Problems: which market, what time period

• Alternate Approach

– Relative volatility of stock price





• Alternate Approach - Bottom Up beta – reflects current business and financial mix

– Can be adjusted in future to reflect changes in business mix

and can be calculated for non traded firms

– Reduces standard error

• The beta of the firm should depend on its

– Products (Commodity Vs Differentiated)

– Operating Leverage (High fixed cost Vs High variable cost)

– Financial Leverage (Higher leverage should imply higher risk)





• Calculating Bottom Up Beta: – Calculate pure regression betas for the business the firm is in –

use simple average – Why?

– Adjust this business beta for average D/E ratio of thebusinesses used to calculate the above.

• Unlevered Beta = βU = Business Beta / (1+ ((1-t)D/E))

– Adjust for operating leverage (difficult to do)

• Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable costs))

– Adjust for financial leverage to come to equity beta

• βL = βU (1+ ((1-t)D/E)) - βdebt (1-t) (D/E)• Second term usually ignored

– D/E - use net debt (debt – cash) or gross debt? Use book valueof D/E





• For firm in multiple businesses: – Calculate regression betas for the businesses the firm is in

– Un-lever this beta using average D/E ratio of the sample

– Calculate weighted average un-levered beta for firm using

market value of businesses as weights – Lever this beta

• A problem one may face is finding comparable firms

– Not enough firms




Advantages of Bottom Up Beta

• Reflect current business mix• Can be adjusted to reflect future business mix

• Can be calculated even if historical data for the firm is

not available but comparable firms data is available –

private business valuation

• Have we really solved the problem of regression betas in

this approach of calculating bottom up betas?




DCF - Issues with Discount Rates - CoD

• Cost of borrowing: – Reflects default risk as well as prevailing interest rates

– Not the same as interest rate of a company’s bond or the interest costs

– Different bonds of a company can have a different rating

– For companies with liquid straight bonds use YTM

– For companies raising fresh debt the latest cost could be used but ensure its

not skewed by other ‘covenants’

– Can use risk free rate (which one?) plus default spread which can be

gauged from rating parameters used by rating agencies (synthetic rating).

Caution – ratings and change in interest rates

• E.g. interest coverage ratios (can vary over time and the rating for the same

interest coverage ratio will change with changing interest rates)

• Size of company will make a difference




DCF - Issues with Discount Rate-WACC

• Use market weights – converting book value of debt to market value

• Element of circularity

• The debt to subtract from firm value to arrive at the value of equity should be

the same debt that is used to compute the cost of capital. Its market value of

debt.

• Preferred – keep separate or club with debt (cost is its dividend yield)

Source: Aswath

Damodaran



Final Word - CoE

• The risk premium we use (historical, current implied oraverage implied) depends on what we are assuming

about the markets

• Third Approach: CAN WE DO AWAY WITH RISK

PREMIUMS AND USE ONLY RISK FREE RATE TODISCOUNT CF? if yes what are you assuming about the

cash flows?

bav 2011 visit ii ppt

Documents