Download - Projecting Financials & Valuations
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Projecting Financials &
Valuation
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Agenda
Management Interaction
Projecting Financials
Estimating Growth Estimation of Discount Rates
Estimation of Cash flow
Valuation Discounted Cash flow Analysis
Relative Valuation
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Agenda
Valuation
Valuation of Mergers and Acquisitions
Choosing the right valuation tool Market Perspective on Relative valuation
Giving Recommendation
Analyzing Financial Services Companies
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Management Interaction
Futuristic Questions
Focused on the broader areas that give you senseof what lies ahead
Strategy: Plans of entering into new businesses
New client acquisition
Technology & its impact on the business & margins
Inorganic acquisition Market share strategies
Rationale behind new geographical forays
Etc.
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Management Interaction
Finance
Expected growth in revenue (management may
not always tell this, so indirect questions asking
the same in like will you grow at minimum of
industry growth rate, etc.)
View of margins and factors affecting it
Any funding plans, ways of funding Pricing strategy
Volume etc.
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Projecting Financials
Building the revenue model Identifying the key revenue drivers
Identifying the Volume measure
Identifying the Pricing measure
Business model Should be most comprehensive
Nature of the business
For e.g. in IT sector there are multiple drivers Geographical breakup (US, Europe, India and RoW)
Location of work: Onsite-Offshore Service Lines
Domains of work etc.
Key driver, however, is the employee base. How?
Building the Infosys revenue model.
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Projecting Financials
Key revenue drivers in different industries
Telecom
Real Estate
Infrastructure Automobile
Auto ancillary
Banking
Media
FMCG
Retail & Hospitality
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Projecting Financials
Building Cost Models Identifying the key costs
Direct costs Labor
Material Basis for projecting:
Capacity expansions, if any
New geographical forays (lower labor costs, availability material etc)
Acquisitions etc.
Also see the trends expected in the raw material prices.
Indirect Costs Selling and Marketing Expenses Need to verify the market & economy scenario
Look at the historical trends and see any cyclicality
General & Administration Expenses
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Projecting Financials
Depreciation: Always project the Depreciation
as a % of average gross block.
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Projecting Financials
Projecting the Other Income
See the schedules to get the break up of the otherincome. It typically comprises:
Interest on deposits (Cash &B
ankB
alance) Dividend on investments (Liquid investments like
MF, others etc)
Others
Typically, project the entire other income based on the cash,bank balance & liquid investments
Projecting Interest Expenses: as % of the loan
Extraordinary Income: Do not project unless youhave high level of conviction about it arising.
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Projecting Financials
Taxes: Project the taxes based on the
management discussions and as % of PBT.
Minority Interest: Ideally, you should projectthe numbers of the subsidiary and consolidate
it with the parent company. However, if the
subsidiary is not big enough, project minority
interest as % of PAT (before Minority iterest)
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Projecting Financials
EPS
Projecting the Number of Shares
Factor in the issue of new shares
ESOP conversion
Factor in what proportion of the debentures will get
converted into equity shares
Inputs from management will be quite valuablefor projecting the diluted EPS.
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Projecting Financials
Dividends: The company board decides thedividends. Typically, the companies in growthphase would give lower dividends and those inmature phase will give higher.
Dividends can be projected as % of PAT or as % ofEquity Capital. Always get feedback from themanagement as to what do they refer internally.
Typically, the companies will not lower thedividends as it is considered a major negativeunless it is able to justify the investors the reasonfor lowering the dividends.
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Projecting Financials
Gross Block
Project Capital Expenditure:
get inputs from the management
See the expansion plan See historical trend in capex per key parameter
(number of user, towers, customers, employees, etc.)
Have some basis like revenue target, market sharetarget, etc.
Get cues from the announcements done by themanagement etc.
Next Year Gross Block = Last Y Gross Block + Capex
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Projecting Financials
Accumulated Depreciation:
Last year Accumulated Depreciation + Current
year Depreciation
Computing Capital Expenditure:
Increase in Gross Block + Increase in Capital Work
in Progress + Increase in Goodwill
Increase in net block + Current year Depreciation+ Increase in Capital Work in Progress + Increase in
Goodwill
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Projecting Financials
Current Assets:
Debtors
Calculate the debtor days. Look at historical trends. Look at
the current market trends. Look at the competition. See howis company placed vis--vis in the coming days. Check new
product launches, if any. Have some rationale assumptions
over their success rates. Based on that predict whether the
company will be more aggressive or liberal.
Cash has to be the balancing figure. Look at the value
of cash. If it is fluctuating by great value, get that
there are other assumptions that are getting wrong.
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Projecting Financials
Inventory
Calculate the inventory days. Interact with the
management. See the market scenario. Have a
view on the demand-supply scenario. Based onthat project the inventory.
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Projecting Financials
Creditor Days:
Calculate the creditor days based on (typically)total costs involved. It should ideally be calculated
on the net purchases. However, if the creditorsinvolve all sorts of entries, it should be calculatedon the total operating costs/ total direct costs.
With the best judgment of whether the company
is in position to ask for higher credit period,project the creditor days and reverse calculate thecreditors.
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Projecting Financials
Provision for Dividends:
Project it as % of the total dividends paid
Provision for Taxes Project it as % of the total taxes paid
Other provisions: See its relevance for the
balance sheet. See how big is the value.
Identify the proper driver for it and project.
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Projecting Financials
Projecting For next 5 years
It is a difficult task indeed. However, you need to
foresee and make the rationale assumptions.
One of the ways could be to assume that the
company will maintain the same market share in
the industry. And using the industry forecasts that
are publicly available.B
ut you must be able tosupport your assumptions with other solid data.
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Projecting Financials
Some basic principles:
Always take the denominator figure as the averageof last two years.
Always keep a tab on the common sized P&L andBalance sheet to see whether your projections aregoing haywire.
Do not waste too much time on one entry at a
time if the projected number does not make muchof a sense.
Not all things will ever be clear for you
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Estimating Growth
Types:
Look at the firms past earnings i.e. its historical
growth rate
Looking at the analysts growth estimates
Fundamental growth of the firm from its
reinvestment
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Estimating Growth
Historical Growth
Arithmetic Versus Geometric Averages
Linear and Log-linear regression models
Time-series to model EPS
Usefulness of Historical growth
Revenue growth Vs Earnings growth
Effects of Firm size
Example
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Estimating Growth
Analyst Estimates What gets covered?
High market capitalization
Institutional Holding
Trading Volume
What is different about the analyst forecasts? Firm specific information that has been made public since the
last earnings report
Macro economic information that may impact future growth
Information revealed by competitors on future prospects
Private information about the firm
Public information other than earnings
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Estimating Growth
Fundamental Determinants Growth = Function ( Reinvestments & its
quality)
gt = (NIt- NIt-1)/ NIt-1
gt: Growth rate in net income
NIt : Net income in year t
By Definition:
NI(t-1) =B
V(t-2) *RoE (t-1)
NIt = BV(t-2) + Retained Earnings (t-1)*
RoE t
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Estimating Growth
Fundamental Determinants
Assuming RoEt=RoEt-1=RoE
gt = (BVt-2 + Retained Earnings t-1-BVt-2)NIt-1*RoE
= Retained Earnings t-1/ NIt-1*RoE
= b * RoE
Where b is retention ratio.
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Free Cash FlowModels
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Valuations
Three Basic Questions
Why do you value a Company?
What do you value in the company?
How do you value a company?
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Valuation
Why do you value a company?
To arrive at the decision on Buy or Sell shares of a
company
To assist you in evaluating whether the value is
getting created or not
To identify the merger or acquisition target
To value the synergy post merger/ acquisition
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Valuation
What do you value in the company?
You can value inventory
You an value the project the company has taken
up
You value the corporate bonds
You can value the managers (value manager)
You can value Equity of the company
You can value the entire firm itself
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Valuation
Approaches to Valuation Discounted Cash Flow Valuation
Dividend Discount Models
Free Cash flow to Equity Models
Free Cash flow to Firm
Relative Valuation Price/ Earnings Multiple
Price/ Sales Multiple
Price/ Book Value Multiple
EV/ EBIDTA Multiple
EV/ Sales Multiple
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Valuation
Computing Discount Rate
It is also called as Expected Rate of Return (ERR)
If you are valuing an equity, it is called as cost of
Equity.
If you are valuing debt, it is cost of debt.
If you are valuing a firm, it is called as Cost of
Capital. So, how do you compute it?
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Valuation
Computing Discounting Rate CAPM
CoE = Rfr+ Beta * (RmRfr)
Rfr is a risk free rate
Beta is the measure of the covariance of stock returns withthat of the market index
Rm is market return
The equation is based on several Assumptions: Investors have homogeneous expectations about asset returns
and variances They can borrow and lend at risk free rate
There are no transaction costs
There are no restriction on short selling
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Valuation
Computing Discounting Rate
CAPM
Risk premium (Rm-Rfr) is the difference between the averagestock returns and the returns on the risk free securities.Typically, the use of longest period seems appropriate.Moreover, the use of geometric mean rather than arithmeticmean takes care of the compounding effect.
Risk premium can vary depending on a. variance inunderlying economy b. Political risk c. Structure of the
market. In country like India typically the risk premium is assumed to
be between 7-8%.
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Valuation
Computing Discounting Rate
CAPM
Risk Free Rate
A short term T-Bill Rate
Current short term government security rate
Current long term government-bond rate
In most valuation cases, the risk free rate that is considered is
the one for long term government bond rate.
In India the long term government rate is: xxxxxx
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Valuation
Computing Discounting Rate
CAPM
Beta: There are 4 points that need to be considered
while estimating Beta. Length of Estimation Period: A long period provides more data
but the firm itself might have changed in its dynamics.Typically, a 5 years of data is advisable
Return Interval: Daily, Weekly, Monthly, etc. Non-Trading bias.Weekly, Monthly data is advised as it helps removing non-
trading periods. Choice of Index
Errors involved in computing Beta.
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Valuation
Computing Discounting Rate
CAPM
Determinants ofBeta
Type ofBusiness: Cyclical businesses have higher betas. Beta
of a firm operating in different businesses will have betas that
are weighted average of betas of the respective business lines.
Degree of Operating Leverage: A degree of operating leverage
is function of the cost structure of the firm and is usually
defined in terms of the relationship between the fixed costsand the total costs. The firm that has higher operating
leverage, i.e. higher proportion of fixed costs in total costs will
have higher variability in EBIT
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Valuation
Computing Discounting Rate
CAPM
Determinants ofBeta
Degree of operating Leverage: Firms A&B. Firm A has 40% of
its costs variable and firm B has 60% of its costs variable. For
expected revenue of Rs125mn, Boom revenue of Rs200mn
and recession revenue of Rs80mn, the EBIT will be as follows:
Costs in Rs mn EBIT in Rs mn
Firm Fixed VariableFixed/Total Expected Boom Recession
A 50 50 0.5 25 70 -2
B 25 75 0.25 25 55 7
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Valuation
Computing Discounting Rate
CAPM
Determinants ofBeta
Financial Leverage: Other things remaining equal, increase in
financial leverage will increase the equity beta of a firm.
Intuitively, increase in the payment of interest expense will
increase the earnings during the boom time and would impact
badly during recession. If the having debt on the balance
sheet is giving tax advantage to the firm, then the Beta can becomputed as:
BetaL = BetaUL *(1+(1-t)*(D/E))
Computing Unlevered Beta Assignment.
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Valuation
Computing Discounting Rate
Arbitrage Pricing Model (APM)
This is used to have further accurate estimate of the
cost of Equity.
It is given by
j=n
CoE= Rfr + Betaj * (E(Rj)-Rfr)j=0
Where Rj is the return on every factor j having Betaj
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Valuation
Computing Discount Rate
According to Grodon Growth model,
P0 = DPS1/ (Ke- g)
So, Ke = (DPS1/ P0) + g
However, using this Ke will always justify the current
price given that is has been computed from thesame.
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Valuation
Computing Discounting Rate Weighted Average Cost of Capital
WACC = E/ (E+D) *Ke + D/(E+D) *Kd
* Value Equity and Debt at the market value not at bookvalue
Computing Cost of Debt, Kd Current level of interest rates: Typically, as the level of interest
rates increases, the cost of debt also increases.
Default risk of the company: As the default risk of the companyincreases, the Kd also increses. If the ratings go up, the Kd willreduce and vice a versa. If the ratings are not available, use therecent interest rates paid by the firm.
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Valuation
Computing Discounting Rate
Computing Cost of Debt, Kd
The tax advantage with the debt: As the interest paid
on the debt is tax deductible, the after tax cost of debtwill be lower than the pre-tax cost of debt.
After Tax Kd = Pre-tax Kd *(1-t)
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Valuation
Estimation of Cash flows
Cash flow to equity
Investor in a firm are entitled to get residual cash flows
from the firm after meeting its all the obligations,including debt payments and after meeting the
reinvestment needs of the organization. So, the cash
flow remaining after operating expenses, interest and
principal payments, and any capital expenditureneeded to maintain the growth rate in projected cash
flow.
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Valuation
Estimation of Cash flows
Cash flow to equity
Unlevered Firm
Revenues Operating expenses
= EBITDA
- Depreciation & amortization
= EBIT- Taxes
= Net Income + Depreciation & Amortization= Cash flows from operations Capital Expenditure working capital
needs
= Free cash flow to equity
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Valuation
Estimation of Cash flows
Cash flow to equity
Unlevered Firm
The Free cash flow to equity can be negative. In that case, the
company needs to come up with the new issue or private
companies need to raise funds from the owners or the
venture capitalists. It can be positive and dividends can be
paid, though not always.
Depreciation: It is a non-cash expenses and also taxdeductible. They provide tax benefit to the extent of:
Depreciation * marginal tax rate
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Valuation
Estimation of Cash flows
Cash flow to equity
Unlevered Firm
Capital Expenditure: A portion of the operating cash flow has
to be invested in maintaining the existing assets and to create
new growth assets. Since the benefits of the growth are
usually reflected in cash flows, so we need to reflect the costs
incurred to create the growth assets in the cash flow.
Relationship between Capex & Depreciation: Firms in highgrowth phase have capex that exceeds the depreciation.
While for the firms in stable growth phase, capital
expenditure and depreciation are at par. This implies that the
ratio of capex to depreciation should decline as the firm
moves from high growth to stable growth phase.
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Valuation
Estimation of Cash flows
Cash flow to equity
Unlevered Firm
Working Capital requirements: Since the funds tied up in theworking capital can not be used anywhere else, they have to beconsidered while computing the cash flow.
Increase in working capital are cash out flows and decreases arecash inflows.
Treatment of cash: By definition, the cash is included incomputation of working capital. However, if the cash is not beingused for the day to day operations of the company, it should notbe considered in computation of working capital. Typically, 2-3%of sales can be considered as normal cash. Mere increase in cashcan not be considered as cash outflow.
Higher the growth, typically, higher will be the working capitalneeds. WC needs also change from business to business.
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Valuation
Estimation of Cash flows Cash flow to equity
Levered Firm (Optimal D/(D+E) Ratio)
Net Income
+ Depreciation & Amortization= Cash flow from operations Capex
- Working capital requirements
- Principal Payments
+ Proceeds from new debts
= Free cash flow to equity Here it is assumed that the principal payments will be done
from the new debt issues.
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Valuation
Estimation of Cash flows
Cash flow to equity
Levered Firm (Optimal D/(D+E) Ratio)
And hence,
Net income
(1-D/(D+E)) * (Capex- depreciation)
(1-D/(D+E)) * Working capital changes
= Free cash flow to equity
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Valuation
Estimation of Cash flows
Cash flow to equity
Levered Firm (Above Optimal D/(D+E) Ratio)
Here, the firm may have to generate disproportionately higher
equity in financing its investments needs to reduce its debt
ratio. It may have to generate funds to repay its principal.
Here, proceeds from the new debt will be lower than:
Principal Payments + * (Capital Expenditure + Working Capital
needs)
Example
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Valuation
Estimation of Cash flows
Cash flow to Firm: In general terms the cash flowto the firm are the earnings after operating
expenses and tax but before paying to any claimholders.
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Valuation
Claim Holder Cash flow to claim holder Discount Rate
Equity Investor
Debt Holders
Free Cash Flow to Equity
+
Interest Expenses (1-t) +
Principal Payments
- New Debt Issues
Cost of Equity
After Tax
Cost of Debt
Preferred Stock Holders Preferred Dividends Cost of Preferred Dividends
Firm = Equity Investors + Debt
Holders + Preferred Stock
holders
FCFF= Free Cash Flow to
Equity + Interest Expenses (1-
tax rate) +Principal
Repayments New Debt
issues + Preferred Dividends
Weighted Average Cost of
Capital
Estimation of Cash flows
Cash flow to Firm
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Valuation
Discounted Cash Flow Models Dividend Discount Models
When individuals buy stocks, they expect returns in terms ofthe expected dividends and the appreciation of the stock
price. So, the hypothesis is that the price itself is the function of
the future expected dividends till infinity.j=n
Price = DPSj / (1+r)j
j=0
DPSj is expected Dividend per share.r is required rate of return on the stock.
To identify the future dividends, the assumptions for thefuture growth rates in earnings and payout ratios are made.
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Valuation
Discounted Cash Flow Models
Dividend Discount Models (DDM)
CAPM is used to identify required rate of return and
assumptions about different variables like Beta,Riskfree rates are made.
Versions of the DDM
Gordon Growth Model
Two Stage DDM
Three Stage DDM
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Valuation
Discounted Cash Flow Models
DDM
Gordon Growth Model
Value of Stock = DPS1 /( r- g) DPS1 is Dividend per share for next year
R is required rate of return for equity investor
g is perpetual growth rate
0
1
2
3
4
6
FY10 FY11E FY12E FY13E FY14E FY1
E
Stable Growth rate
g %
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Valuation
Discounted Cash Flow Models
DDM
Estimating stable growth rate
As the dividend is expected to grow at a stable rate forever, firms
other measures are also expected to grow at same rate. For if, thedividends grow at a higher rate (say 8%) than earnings (say 6%),over the years, dividends will exceed the earnings. In the reversecase, the dividend payout will converge to zero, which is not asteady state.
The expected growth rate can not be greater than the economys
nominal growth rate as, if it continues, the company will bebigger than the economy over the years, that is quite irrational.Hence the stable growth rate should be around the economy snominal growth rate.
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Valuation
Discounted Cash Flow Models
DDM
Estimating stable growth rate
In country like India, the nominal growth rate in the economyin the long term will be say 2-3% with expected inflation of 4-
5%. So, the stable growth assumption should vary too much
from 6-8%. The growth rate can not be more than 1-2% above
the growth rate in economy.
Limitations of the Model It is extremely sensitive to the input of growth rate.
Example
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Valuation
Discounted Cash Flow Models
DDM
Two Stage DDM
Here, it is estimated that the growth happens in two stages.
First few years of higher growth rates followed by the stable
growth rate
High Growth Phase gh Stable growth phase gn
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Valuation
Discounted Cash Flow Models DDM
Two Stage DDM The value of the stock is given by:
Present value of high growth phase + Present value of TerminalValue.
= DPS0 * (1+gh) *(1-((1+gh)/(1+gn))^n)/ (r- gh) [ Growth Phase]
+DPS0 *(1+gh)^n *(1+gn)/ ((r-gn)*(1+r)^n)
[PV of terminal value]
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Valuation
Discounted Cash Flow Models DDM
Two Stage DDM Limitations
In this model, it is assumed that the high growth phase will fall to a
stable phase abruptly. Also, in the stable growth phase, the payout is expected to go up
significantly.
Moreover, other parameters like Beta, RoA, etc. are expected to beinline with the stable growth phase.
It is difficult to estimate the length of the high growth phase and thevalue of the high growth itself.
The terminal value contributes a large portion of price and it issensitive to assumptions of the stable growth rate.
est Uses: In the pharmaceucitcal company whose patent is about thelapse in the nth year.
Example
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Valuation
Discounted Cash Flow Models
DDM
Three Stage DDM
Value of the stock price =
high growth phase + Transition Phase + Terminal Value
0%
2%
4%
6%
8%
10%
12%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
growth %
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Valuation
Discounted Cash Flow Models
DDM
Three Stage DDM
Example
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Valuation
Discounted Cash Flow Models
Free Cash Flow to Equity (FCFE)
Net Income + Deprecation Capital Spending -
Working Capital Principal Payments + New DebtIssues
For levered firm with optimal debt ratio,
Net Income + (1- ) * (Capital Spending Deprecation)
(1- ) * Working Capital
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Valuation
Discounted Cash Flow Models
Free Cash Flow to Equity (FCFE)
Why dividends different from FCFE?
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Valuation
Relative Valuation
Price to Earnings Multiple
Estimating P/E ratio from the fundamentals
P0 = DPS1/ (r-g)
Replace DPS1 by EPS0 * (1+g) * Payout Ratio
So,
P0 = EPS0 * Payout Ratio * (1+g) /( r-g)
P0/EPS0 = Payout Ratio * (1+g)/ (r-g)
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Valuation
Relative Valuation
Price to Earnings Multiple
Determinants of P/E Ratio
Payout Ratio
Growth rate
Discount rate
Riskiness of the firm (Beta)
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Valuation
Relative Valuation
Price to Earnings Multiple
Investment strategies that relate P/E ratios with
expected growth rate P/E to growth ratio is used to measure the relative value, with
lower value compared to peers is associated with the
undervaluation.
There is no reason why a firm with lower P/E ratio with higher
expected growth is under valued. Lower P/E multiple could beindicator of higher risk or higher interest rates.
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Valuation
Relative Valuation
Price to Book Value Multiple
Hence,
P0 = RoE * BV0 * Payout Ratio * (1+g)/ (r-g)P0/ BV0 = RoE * Payout Ratio / (r-g). Assuming RoE is
based on expected earnings
Now, RoE * Payout = RoE g
Hence,
P0/ BV0 = (RoE- g)/ (r-g)
This implies if RoE exceeds the required rate of return (r),the price will exceed the book value and vice-a-versa.
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Valuation
Relative Valuation
Price to Book Value Multiple
Equation for a high growth firm
RoE [ Payouth* (1+gh) *(1-((1+gh)/(1+gn))^n)/ (r- gh)
+ Payoutn *(1+gh)^n *(1+gn)/ ((r-gn)*(1+r)^n) ]
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Valuation
Relative Valuation
Price to Book Value Multiple
Relationship with RoE
RoE impacts the P/ Bv in two ways
Directly (it being the numerator the ratio)
Indirectly (it affecting the growth of the company
indirectly)
Example
When RoE = Required rate of return, r, the price is equal to
Book Value.
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Valuation Relative Valuation
Price to Book Value Multiple
Looking for undervalued securities
Generally, P/ Bv is positively related to the RoE
The point of interest could be the securities having a. higherRoE and lower P/ Bv b. lower RoEs and higher P/ Bv
Overvalued
Low RoE
Higher P/ Bv
Low RoE
Low P/Bv
High RoE
High P/ Bv
Undervalued
High RoE
Low P/Bv
RoE- r
P/Bv
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Valuation
Relative Valuation
Price to Book Value Multiple
Now, lets look at the determinants of RoE
To the extent that there is correlation between current RoE andfuture RoE, it is fair to use the historical data. However, when the
competitive environment is changing, focusing on current RoE
could be dangerous and can lead to significant errors in valuation.
The difference between the RoE and required rate of returns is
the measure of the firms capacity to earn supernormal profits in
the business it operates.
One of the frameworks that can be used to analyze the degree of
such supernormal profits can be given by Porters Five Force
Model.
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Valuation
Relative Valuation
Price to Book Value Multiple
Limitations
Book values are affected by accounting practices (like inearnings)
Book value may not carry much meaning for services firm that
does not have significant assets
A firm having sustained string of negative profits can lead to
negative P/ Bv ratio
Empowering People Transforming Businesses86
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Relative Valuation
Price to Sales Multiple
Disadvantage of Price to sales ratio