Business Valuation with Special Emphasis to Derivative Financial

Instruments CMA Gautam Mitra

Burdwan University, West Bengal

Q. X is willing to invest in index future market lot is 200 units. Spot price of 1 unit is Rs. 1,100 margin money is 10% bank interest rate is 9% three months index future is Rs. 1,122. Take investment decision.

Definition

• Valuation is not an objective exercise, any preconceptions and biases that an analyst brings to the process will find their way into value.

Price v/s Value

• A lawyer buys a book for Rs. 40,000 in order to perform an assignment having remuneration of Rs. 2,50,000. After reading the book he found it useless. What is the value of the book ?• An oil reserve of Petronet L&G finds that oil price is Rs. 70 per barrel

whereas extraction cost per barrel is Rs. 110, again what is the value of oil to the company ? Again what is the value, when oil price reaches to Rs. 130 ?

Foundation of Business valuation

• Investor does not pay more for an asset than it is worth. He should not buy most assets simply for aesthetic or emotional reasons. Asset price can not be justified only on the argument that there are investors around who will pay a higher price in future.

Why Valuation ?

Purpose of valuation Examples

Transactions M&A, Reverse merger, IPO, ESOP, Buyback of share

Court cases Bankruptcy, Divorce cases, Intellectual Property Disputes

Compliances Fair value accounting(IFRS 13), Tax issues

Planning Estate planning, personal financial planning, M&A planning

3 Approaches to Business Valuation

• DCF• Relative Valuation • Contingent claim valuation

Uncertainties in Business Valuation

1. Macroeconomic factors2. The Business3. Growth potential in the industry in which it operates4. How is the business positioned ?5. Who are competitors ?6. What is the quality and stability of the management ?

Principles of Valuation

• Substitution- Business A can be sold at X amount. If a similar business is available at a price lower than X then business A has worth less than X amount.

• Alternatives- No single decision maker should be confined to considering a single transaction. He must consider several alternatives.

• Time Value of Money- Getting appropriate discount rate could be debatable issue and may have estimation bias.

• Expectation- Future valuation of a project by a company like L&T may be well expected well before maturity, however for new companies it might be very difficult to predict extent and direction of growth.

• Risk and Return- Harry Markowitz model was first to quantify risk and derive optimal portfolio. Markowitz model assumed (i) Investor is risk averse; (ii) He prefers greater wealth for higher consumption; (iii) Given two portfolios of similar risk one would chose a portfolio with higher

expected return. These assumption constitutes integral part of valuation exercise.

• Reasonableness and Reconciliation- 1. Inconsistency in judgement and assumptions.

2. Conceptual Flaws 3. Projection modelling and formula errors

Myths about valuation

1. A valuation is an objective searched for true value.2. Valuation models are quantitative and greater the inputs better is the result.3. A well researched an well done valuation is perpetual in nature.-”When the facts

change, I change my mind and what do you do, Sir?”-John Maynard Keynes 4. A good valuation provides a precise estimate of values-the pay off to valuation

is greatest when valuation is least precise.5. A valuer should assume that markets are inefficient-in an efficient market value

is equal to price.6. Value matters and not the valuation- ignored points

1. brand name2. return on project3. appropriate price on high growth.

Valuation of Stock index future

1. Consider a three months future contract on NIFTY. Assume that the spot value of the index is Rs. 1,090. Discrete rate of interest is 12% per annum. Discrete rate of yield on shares underlying NIFTY is 6% per annum. Multiplier is 200(market lot). Compute the values of one future contract

Option Valuation