ACAD-EDGE

EDITION 5
Valuation Basics
Table of Contents
PURPOSE OF THE DOCUMENT .................................................................................................................... 3
VALUATION INTRODUCTION....................................................................................................................... 3
RELEVANCE OF VALUATION ........................................................................................................................ 3
VALUATION PROCESS.................................................................................................................................. 4
DISCOUNTED CASH FLOW VALUATION ...................................................................................................... 5
DIVIDEND DISCOUNT MODEL ................................................................................................................. 7
GORDON GROWTH MODEL .................................................................................................................... 8
The Present Value of Growth Opportunities .......................................................................................... 9
TWO-STAGE DIVIDEND DISCOUNT MODEL .......................................................................................... 10
THE H-MODEL ....................................................................................................................................... 11
FCFF & FCFE VALUATION APPROACH ................................................................................................... 12
FORECASTING FREE CASH FLOW ...................................................................................................... 14
RELATIVE VALUATION ............................................................................................................................... 15
PRICE MULTIPLES / PUBLIC COMPS VALUATION METHOD .................................................................. 15
PRICE MULTIPLES .................................................................................................................................. 19
Price to Earnings ............................................................................................................................... 19
Price to Book Value Multiple: ........................................................................................................... 20
Diluted Market Capitalization/Book value........................................................................................ 20
PE/EG (Earnings Growth) Ratio ......................................................................................................... 20
Enterprise Multiples ............................................................................................................................. 20
EV/Sales ............................................................................................................................................ 20
EV/EBITDA:........................................................................................................................................ 20
EV/EBIT ............................................................................................................................................. 20
OTHER VALUATION METHODS ................................................................................................................. 21
APPENDIX .................................................................................................................................................. 22

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 PURPOSE OF THE DOCUMENT
The purpose of this document is to introduce the reader to the various topics of Valuation. It
is advised that he/she supplements this with more comprehensive notes of renowned authors
and bloggers- to cover the topics in more detail.

VALUATION INTRODUCTION

Valuation is the estimation of an asset’s value based on variables perceived to be related to

future investment returns, or based on comparisons with closely similar assets.

The intrinsic value of an asset is its value given a hypothetically complete understanding of
the asset’s investment characteristics.
The assumption that the market price of a security can diverge from its intrinsic value—as
suggested by the rational efficient markets formulation of efficient market theory— underpins
active investing.
Intrinsic value incorporates the going-concern assumption, that is, the assumption that a
company will continue operating for the foreseeable future. In contrast, liquidation value is the
company’s value if it were dissolved and its assets sold individually.
Fair value is the price at which an asset (or liability) would change hands if neither buyer nor
seller were under compulsion to buy/sell and both were informed about material underlying
facts.

RELEVANCE OF VALUATION

Valuation is useful in a wide range of tasks. The following section lays out the relevance of
valuation in different cases

How much should be paid to buy the company?

Acquisitions

Is our company undervalued/

vulnerable to a raider? Hostile
Defence Divestitures
How much should the company
or division be sold for?
Role of
Valuation
What is the underlying
value?
Debt Fairness
Offerings Opinions
Is the price offered for the
company/division fair?
Public
Equity
For how much should we sell a stake of the Offerings

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 VALUATION PROCESS
The valuation process has five steps:
I. Understanding the business.
II. Forecasting company performance.
III. Selecting the appropriate valuation model.
IV. Converting forecasts to a valuation.
V. Applying the analytical results in the form of recommendations and conclusions.

Understanding the business includes evaluating industry prospects, competitive position, and
corporate strategies, all of which contribute to making more accurate forecasts. Understanding
the business also involves analysis of financial reports, including evaluating the quality of a
company’s earnings.

In forecasting company performance, a top-down forecasting approach moves from

macroeconomic forecasts to industry forecasts and then to individual company and asset
forecasts. A bottom-up forecasting approach aggregates individual company forecasts to
industry forecasts, which in turn may be aggregated to macroeconomic forecasts.

Selecting the appropriate valuation approach means choosing an approach that is:
• consistent with the characteristics of the company being valued;
• appropriate given the availability and quality of the data; and
• consistent with the analyst’s valuation purpose and perspective.

In general terms, there are three approaches to valuation:

• Intrinsic Valuation; relates the value of an asset to its intrinsic characteristics: its
capacity to generate cash flows and the risk in the cash flows. In its most common
form, intrinsic value is computed with a discounted cash flow valuation, with the value
of an asset being the present value of expected future cash-flows on that asset.
• Relative Valuation; estimates the value of an asset by looking at the pricing of
'comparable' assets relative to a common variable like earnings, cash-flows, book value
or sales.
• Contingent Claim Valuation; uses option pricing models to measure the value of assets
that share option characteristics.
Two important aspects of converting forecasts to valuation are sensitivity analysis and
situational adjustments.
• Sensitivity analysis is an analysis to determine how changes in an assumed input
would affect the outcome of an analysis.
• Situational adjustments include control premiums (premiums for a controlling
interest in the company), discounts for lack of marketability (discounts reflecting the
lack of a public market for the company’s shares), and illiquidity discounts (discounts
reflecting the lack of a liquid market for the company’s shares).

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 DISCOUNTED CASH FLOW VALUATION

What is it: In discounted cash flow valuation, the value of an asset is the present value of the
expected cash flows on the asset. Every asset has an intrinsic value that can be estimated, based
upon its characteristics in terms of cash flows, growth and risk. 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.

DCF Model: The accompanying diagram is an illustration of the flow of items in a simple DCF
Model.

Trivia –
• This is the reason why analysts and investors appear obsessed with quarterly earnings as
these provide latest guidance to trends in valuation projection models, as well as full-
year EBITDA for multiples comparison.
• If quarterly (or annuals) show deviation from analyst/investor assumptions – the stock
price will move as long-term assumptions get revised.

Information Needed: To use discounted cash flow valuation, you need

• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get
present value

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 DCF Process

• Project the operating results and free cash flows of the business over the forecast
Projections / FCF period (typically 10 years, but can be 5-20 years depending on the profitability
horizon)

• Estimate the exit multiple and/or growth rate in perpetuity of the business at the
Terminal Value end of forecast period

• Estimate the company's weighted-average cost of capital to determinethe

Discount Rate appropriate discount rate range

• Determine a range of values for the enterprise by discounting the projected free
Present Value cash flows and terminal value of the present

• Adjust the resulting variation for all assets and liabilities not accounted forin cash
Adjustments flow projections

Advantages: DCF offers the following advantages:

• Since DCF valuation, done right, is based upon an asset’s fundamentals, it should
be less exposed to market moods and perceptions.
• If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted
cash flow valuation is the right way to think about what you are getting when you buy an
asset.
• DCF valuation forces you to think about the underlying characteristics of the firm, and
understand its business. If nothing else, it brings you face to face with the assumptions you
are making when you pay a given price for an asset.
Disadvantages: DCF offers the following disadvantages:
• Since it is an attempt to estimate intrinsic value, it requires far more explicit inputs and
information than other valuation approaches
• These inputs and information are not only noisy (and difficult to estimate), but can be
manipulated by the analyst to provide the conclusion he or she wants. The quality of the
analyst then becomes a function of how well he or she can hide the manipulation.
• In an intrinsic valuation model, there is no guarantee that anything will emerge as
under/over-valued. Thus, it is possible in a DCF valuation model, to find every stock in a
market to be overvalued. This can be a problem for
o equity research analysts, whose job it is to follow sectors and make
recommendations on the most under and overvalued stocks in that sector
o equity portfolio managers, who have to be fully (or close to fully) invested in
equities.

When DCF Valuation works best: At the risk of stating the obvious, this approach is designed
for use for assets (firms) that derive their value from their capacity to generate cash flows in the

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future. It works best for investors who either

• have a long-time horizon, allowing the market time to correct its valuation mistakes and for
price to revert to “true” value or
• are capable of providing the catalyst needed to move price to value, as would be the case if
you were an activist investor or a potential acquirer of the whole firm

DIVIDEND DISCOUNT MODEL

The DDM is the simplest and oldest present value approach to valuing stock.

The Expression for a Single Holding Period

The Expression for Multiple Holding Periods

FINDING THE STOCK PRICE FOR A FIVE-YEAR FORECAST HORIZON

Example 1- For the next five years, the annual dividends of a stock are expected to be $2.00,
$2.10, $2.20, $3.50, and $3.75. In addition, the stock price is expected to be $40.00 in five
years. If the required return on equity is 10 percent, what is the value of this stock?

Solution 1- The present values of the expected future cash flows can be written out as

V0=2.00/ (1.10)1 + 2.10/(1.10)^2 + 2.20(1.10)^3 + 3.50(1.10)^4 + 3.75(1.10)^5 +

40.00(1.10)^5

Calculating and summing these present values gives a stock value of V0 = 1.818 + 1.736 +
1.653 + 2.391 + 2.328 + 24.837 = $34.76.

The five dividends have a total present value of $9.926 and the terminal stock value has a
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present value of $24.837, for a total stock value of $34.76.
GORDON GROWTH MODEL
The Gordon growth model, developed by Gordon and Shapiro (1956) and Gordon (1962),
assumes that dividends grow indefinitely at a constant rate. This assumption, applied to the
general dividend discount model, leads to a simple and elegant valuation formula that has been
influential in investment practice

The Gordon growth model can also be used to value the noncallable form of a traditional
type of preferred stock, fixed-rate perpetual preferred stock (stock with a specified dividend
rate that has a claim on earnings senior to the claim of common stock, and no maturity date).
Perpetual preferred stock has been used particularly by financial institutions such as banks to
obtain permanent equity capital while diluting the interests of common equity. Generally, such
issues have been callable by the issuer after a certain period, so valuation must take account of
the issuer’s call option. Valuation of the noncallable form, however, is straightforward.

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If the dividend on such preferred stock is D, because payments extend into the indefinite future
a perpetuity (a stream of level payments extending to infinity) exists in the constant amount of
D. With g = 0, which is true because dividends are fixed for such preferred stock, the Gordon
growth model becomes

The discount rate, r, capitalizes the amount D, and for that reason is often called a
capitalization rate in this expression and any other expression for the value of a perpetuity.

The Present Value of Growth Opportunities

The value of a stock can be analyzed as the sum of

1) the value of the company without earnings reinvestment, and
2) the present value of growth opportunities (PVGO).

PVGO, also known as the value of growth, sums the expected value today of opportunities to
profitably reinvest future earnings.
For any company, the actual value per share is the sum of the no-growth value per share and the
present value of growth opportunities (PVGO)

Example Suppose that MSEX is expected to have average EPS of $0.79 if it distributed all
earnings as dividends. Its required return of 9.25 percent and a current price of $18.39 gives

$18.39 = ($0.79/0.0925) + PVGO

= $8.54 + PVGO

where PVGO = $18.39 − $8.54 = $9.85. So, 54 percent ($9.85/$18.39 = 0.54) of the company’s
value, as reflected in the market price, is attributable to the value of growth.

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 TWO-STAGE DIVIDEND DISCOUNT MODEL

The two-stage DDM is useful because many scenarios exist in which a company can achieve a
supernormal growth rate for a few years, after which time the growth rate falls to a more
sustainable level
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 THE H-MODEL
The basic two-stage model assumes a constant, extraordinary rate for the supernormal growth
period that is followed by a constant, normal growth rate thereafter. The difference in growth
rates may be substantial. In some cases, a smoother transition to the mature phase growth rate
would be more realistic. Fuller and Hsia (1984) developed a variant of the two-stage model in
which growth begins at a high rate and declines linearly throughout the supernormal growth
period until it reaches a normal rate at the end. The value of the dividend stream in the H-model
is

There are two basic three-stage models. In one version, the growth rate in the middle stage is
constant. In the second version, the growth rate declines linearly in Stage 2 and becomes
constant and normal in Stage 3.

Multistage DDM models can accommodate a wide variety of patterns of expected dividends.
Even though such models may use stylized assumptions about growth, they can provide useful
approximations.

Dividend growth rates can be obtained from analyst forecasts, statistical forecasting models,
or company fundamentals. The sustainable growth rate depends on the ROE and the earnings
retention rate, b: g = b × ROE. This expression can be expanded further, using the DuPont
formula, as

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 FCFF & FCFE VALUATION APPROACH

Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows
available to, respectively, all of the investors in the company and to common stockholders.

Analysts like to use free cash flow (either FCFF or FCFE) as the return:
• if the company is not paying dividends;
• if the company pays dividends but the dividends paid differ significantly from the
company’s capacity to pay dividends;
• if free cash flows align with profitability within a reasonable forecast period with
which the analyst is comfortable; or
• if the investor takes a control perspective.

The FCFF valuation approach estimates the value of the firm as the present value of future
FCFF discounted at the weighted average cost of capital:

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 The value of equity is the value of the firm minus the value of the firm’s debt:
Equity Value = Firm value – Market value of debt

Dividing the total value of equity by the number of outstanding shares gives the value per
share.

The WACC formula is:

The value of the firm if FCFF is growing at a constant rate is

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 FORECASTING FREE CASH FLOW

Computing FCFF from Net Income

FCFF=Net income available to common shareholders (NI)

Plus: Net non-cash charges (NCC)
Plus: Interest expense × (1−Taxrate)
Less: Investment in fixed capital (FCInv)
Less: Investment in working capital (WCInv)

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

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 RELATIVE VALUATION
PRICE MULTIPLES / PUBLIC COMPS VALUATION METHOD

• DCF is theoretically the most valid method to value assets or businesses. Academic
literature on valuing companies largely stress DCF analysis as the correct route to the right
answer. However, most financial analysts know from experience that the assumptions
necessary to perform a DCF calculation can generate an impracticably broad range of
possible outcomes.
• The alternate valuation approach known as price multiples (also known as market multiples,
direct comparison, comparable companies, trading comparables, public comparables, or

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 relative valuation) is widely used in practice.
The primary reason for the popularity of public comps valuation analysis is the model’s
simplicity. Unlike the DCF methods, valuations based on price multiples do not require detailed
multiple-year forecasts of a number of parameters, including growth, reinvestment, and cost of
capital.

• Under the price multiple approach, a current measure of performance (or a single forecast of
performance) is converted into a value through application of a price multiple for comparable
firms
• Measures of performance used to create price multiples may be earnings, sales, cash flows,
book assets or book equity.

Applying a P/E for relative valuation

You are analysing an Example company with $10 million in net income. Comparable firms are
currently trading in the market at 20 times earnings. This price multiple is calculated by dividing
the price per share by comparable firm’s EPS

Net Income for Example firm $ 10 (Millions)

Comparable Firm P/E Ratio 20.0x

Relative Valuation of Example firm based on P/E $200.0(Millions)

Concept behind Price Multiples

• The concept is that similar assets should sell at similar prices. Based on this principle, one
can value an asset or stock by finding a closely comparable asset that has been sold between
a reasonably informed buyer and seller.
• DCF models estimate the intrinsic value of a firm. Price multiples value a firm relative to
how similar firms are valued by the market at the moment.
• An asset expensive on an intrinsic value basis may be cheap on a price multiple basis.
• The reliability of this method of valuation depends on the ability to identify publicly traded
stocks that are “comparable” to the company we are valuing.

Analysis of selected publicly traded companies involves the following steps:

1. Creating the appropriate universe of comparable companies;
2. Gathering the necessary information for the analysis;
3. Performing basic financial and strategic analysis;
4. Removing non-recurring items and normalizing the income statement;
5. Determining and calculating the relevant multiples
6. Deriving a preliminary implied valuation range for the target company.

Details on the steps involved:

Choose comparable firms: since we scale prices of other firms to value the firm being analyzed,
we would like to use data of firms that are as similar as possible to the firm that we value. The
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flip side of this is that by specifying criteria that is too stringent for similarity, we end up with
too few firms to compare.
• In selecting the sample of comparables, you need to balance these two conflicting
considerations: size and relevance.
o What happens when your comp group is too small? The idiosyncrasies of individual
firms affect the average or median multiples so much that it is no longer a
meaningful or representative multiple. The idea is to obtain as large a sample as
possible so that the idiosyncrasies do not affect the valuation as much, yet to not to
choose too large a sample that “comparable firms” are not comparable to the on that
you value.
• Selection of comps is more “art” than “science.” The trick is selecting truly comparable
firms and choosing the right scaling bases – the right multiples. Common criteria:
o Operations: Standard Industry Classification (SIC codes), Business Model or
Strategy, Technology and Capabilities, Products, Distribution Channels,
Clientele or Customers. Seasonality or Cyclicality, Geographic Markets
o Financial Aspects: Size, Capital Structure or Leverage, Margins & Profitability,
Trading History, Growth prospects, Shareholder base
• Sources for comps include: Proxy Statements (Peer group index section), 10K/IPO
Prospectus (Competitor section), other searching via SIC codes, news articles, Debt &
Equity Research Analyst reports, Industry research reports, Bloomberg, Company
Management, etc.
• Gathering Public Information –
o 10-K or annual report from latest fiscal year, financial performance and data, options
information (and shares outstanding from most recent filing). The following website
can be used for a free download of 10K: http://sec.gov
o 10-Q from latest quarter (calculate LTM or latest 12-month performance), balance
sheet information, shares outstanding
o News Announcements – Bloomberg, Reuters, thedeal.com, Dow Jones
Interactive/Factiva, Yahoo Finance, Earnings Announcements (often indicates info
before filing with SEC)
o EPS estimates - First Call and IBES (Institutional Brokers’ Estimate System), Factset
(First Call) and Bloomberg (IBES)
o Research reports – Thomson Reuters, ET Intelligence
Share price – Yahoo Finance, etc.

Best Practices: footnote your assumptions, always check database numbers (use SEC-filed
documents in case of US Companies), navigate and search the financial statements (materiality
issue)

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 Typical Multiples:

Multiple Numerator Denominator What Is Valued

Price/Earnings Price per Common EPS Common Equity
Share

Enterprise Value of Net Debt + EBIT Whole Firm

Value/EBIT Equity
EV/EBITDA Value of Net Debt + EBITDA Whole Firm
Equity
EV/Sales Value of Net Debt + Sales Whole Firm
Equity
Price/Book value Price per Common Book Value of Common Equity
Share Common
Equity per share
EV/FCF Value of Net Debt + FCF Whole Firm
Equity
Price/Equity Cash Value of Common Equity Cash Flow Common Equity
Flow Equity

• Average across industry: once you have a sample of firms that you consider to be similar to
the firm you value, you can average the prices that investors are willing to pay for
comparable firms in order to obtain a price for your firm (or target).

Advantages of Price Multiples:

• Common sense approach: similar companies should sell for similar prices.
• Reliance on market’s consensus view of growth, returns and risk for comparable companies
rather than one’s own projections.
• Easy to understand and apply.

Limitations of Market Multiples:

• Difficult to find companies that are “truly comparable”
• Data for “pure play” firms may be available only as segment data for multi-division firms
severely limiting the analysis because no market prices are available
• The following types of companies may have few or no comparables:
o Small companies – Publicly traded firms tend to be large, thus, it is often not
possible to find comparables for small companies. The problem with using large
publicly traded firms as comparables is that they may be less risky and they may
have lower growth prospects.
o Unique businesses – By their very nature unique businesses may lack comparables.
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 o New sectors or unusually high growth rates
o Companies going through period of change – (short term measures unreliable)

• Subjective Analysis: The choice of comparable firms is subjective and can be tailored to
justify the conclusion the analyst wants to reach. Similarly, in choosing a multiple, there are
a number of possible choices – price/earnings ratios, price/cash flow ratios, price/book
value ratios, price/sales ratios, among others. The one or ones chosen may best fit the
analyst’s biases. Finally, once the average multiple is obtained, subjective judgments may
be made.
• Builds in Errors (Overvaluation or Undervaluation) that the Market Might Be Making in
Valuing these Firms.
• Company Being Valued Isn’t Average.
• As long as differences persist in fundamentals between the firm being valued and
comparables, significant valuation errors may be made.
• Use across Countries: Don’t compare multiples in different countries with the goal of
finding undervalued and overvalued markets. This cannot be done without controlling for
differences in the underlying variables such as different accounting methods, interest rates
and expected growth in real GNP.
• Use across Time: Comparisons are often made using multiples across different time periods
(e.g. P/E multiple for a specific sector is at a ten-year low). As fundamentals (interest rates,
expected growth) change over time, the multiple will change.

PRICE MULTIPLES
Price to Earnings

In calculating a P/E, the numerator most commonly used is the current price of the common
stock, which is generally easily obtained and unambiguous for publicly traded companies.
Selecting the appropriate EPS figure to be used in the denominator is not as straightforward.
The following two issues must be considered:

• the time horizon over which earnings are measured, which results in alternative
definitions of P/E, and
• adjustments to accounting earnings that the analyst may make so that P/Es for various
companies can be compared.

Common alternative definitions of P/E are trailing P/E and forward P/E.

• A stock’s trailing P/E (sometimes referred to as a current P/E) is its current

market price divided by the most recent four quarters’ EPS. In such
calculations, EPS is sometimes referred to as “trailing 12-month (TTM) EPS.”

The forward P/E (also called the leading P/E or prospective P/E) is a stock’s current price
divided by next year’s expected earnings. Trailing P/E is the P/E usually presented first in stock
profiles that appear in financial databases, but most databases also provide the forward P/E.

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 Price to Book Value Multiple:

This is calculated as:

Diluted Market Capitalization/Book value.

Where Book Value = Share Capital + Reserves.

P/B is more stable as compared to P/E.

PE/EG (Earnings Growth) Ratio:

It is calculated as:
PE/Expected Earnings Growth (3-year CAGR).
As a substitute one may also use historical earnings growth.

Enterprise Multiples:

Enterprise Multiples measure value available to the whole enterprise. The numerator is the
Enterprise Value as calculated before while the denominator can only include Sales, Gross
Profit, EBITDA and EBIT. If one went further down and included items like PBT or PAT, it
would go against the principle of consistency as it would depend on factors outside the purview
of the enterprise.

Enterprise value is Capital Neutral i.e. it measures efficiency of the assets deployed rather than
a particular type of capital and so the denominator must also be capital neutral.

EV/Sales:

The metric is generally used for companies that are yet to break even or have faced an
unexpected loss in operational earnings.

EV/EBITDA:

This is one of the most commonly used multiple by professionals as the metric captures
operational efficiency of the firm.

EV/EBIT:

This is considered to be a variant of EV/EBITDA and is generally not preferred as depreciation

and amortization methods can have an impact on the multiple. However, it is extensively used
in case of capital-intensive sectors like cement.

In general, Enterprise multiples are considered to be superior over the equity variables due to
the following reasons:

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 • Sales, EBITDA and EBIT are more stable and are much more difficult to improve due
to ‘window dressing’ as compared to EPS.
• Enterprise multiples are capital neutral and reflect operational efficiency of the firm.

• Reflect the actual selling price of the firm as equity value is based mainly on the short-
term trends rather than the long-term sustainable profitability which is to be considered
during M&As.
• It is difficult to implement Equity Comparable in case of loss-making companies.

OTHER VALUATION METHODS

• Breakup Value: This method assesses the cumulative cash flow resulting from selling off
divisions and hard assets of the company (generally in multiple transactions) and netting the
proceeds against all remaining liabilities. This method is useful if the acquirer believes the
company is worth more “dead” than “alive.” It provides an estimate of the downside in case
the anticipated strategy fails. Implementation of this approach requires estimates of prices
one could get if various subsidiaries or divisions were sold off independently as viable
businesses.
• Liquidation Value – Net Asset Value Method: This approach assumes all assets are sold
individually to generate the best obtainable prices and all liabilities are paid off. “Buffett”
approach. Often the analysis does not assume the maintenance of any division or subsidiary
as a going concern. All assets are converted to cash. Typically assets are valued at “saleable
value.” Might be worth more liquidated than as a going concern. Conservative approach is
better - Inventory could be difficult to sell - A/R difficult to collect, Land difficult to sell.
For example, a company’s inventory may be worth only 50%, accounts receivable (A/R)
might only be 80% of A/R under 60 days old, and for fixed assets like PP&E it could be
anywhere from zero to less than 50% of the value. These figures will depend largely on the
industry and also depend on the timing of the liquidation process.
Watch for hidden liabilities: under-funded pensions plan and retiree medical benefits,
warranties and contingencies. Never underestimate the costs and problems of
liquidation, such as the costs of running a company as it is closed down, managing
unmotivated personnel (may require continuation bonuses). Debts are sure; assets are
not.

• Replacement Value: You estimate the cost of replacing the target company with all new
plant, equipment and the like. Include cost of hiring and training of personnel, designing
and producing products, establishing markets and installing systems of control. This
analysis may be helpful to deciding whether to enter the target industry by starting from
scratch versus buying an existing company.

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 APPENDIX

Sum of the Parts

Most large companies operate in more than one business. Valuing a diversified company
requires separate valuations for each of its businesses and for the core operations. This method
of valuing a company by parts and then adding them up is known as SOTP or its full form Sum
of the Parts valuation and is commonly used in practice by stock market analysts and
companies themselves.

SOTP Valuation simplified using an example –

Let us understand Sum of the Parts valuation using an example of a large conglomerate
company (ticker MOJO) operates the following business segments

Sum of Parts Example - MOJO Company

The common valuation techniques are Relative Valuations, Comparable Acquisition

Analysis and the Discounted Cash Flow approaches. These techniques can be applied to
value MOJO Corp, however, before we do so, let us answer the questions below –

SHOULD YOU APPLY DISCOUNTED CASH FLOW APPROACH TO VALUE MOJO?

Yes, you can. However, if you do so, valuation would be technically INCORRECT. Reason
– You can use DCF Financial Modeling to value segments like Automobiles, Oil and Gas,

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 Software and Ecommerce. However, Banks are typically valued using the Relative valuation
approach (usually Price to Book value) or Residual Income Method.

SHOULD YOU APPLY RELATIVE VALUATION APPROACH TO VALUE MOJO?

Yes, you can do so. But do you think a single valuation methodology like PE Ratio,
EV/EBITDA, P/CF, Price to book Value, PEG Ratio etc. is appropriate to value all the
segments. Obviously, this would again be technically INCORRECT.
Reason – If Ecommerce segment is unprofitable, applying a blanket PE multiple for valuing all
segments will not make much sense. Likewise, banks are correctly valued using Price to Book
value approach than the other available multiples.

WHAT IS THE SOLUTION?

The solution is to value the different parts of the business separately and add the values of the
different parts of the business together. This is a sum of parts or SOTP valuation.

HOW DO WE APPLY SUM OF PARTS VALUATION IN THE CASE OF MOJO?

In order to value the conglomerate like MOJO, one can use different valuation tools to value
each segment.
• Automobile Segment Valuation – Automobile Segment could be best valued using
EV/EBITDA or PE ratios.
• Oil and Gas Segment Valuation – For Oil and Gas companies, the best approach is to
use EV/EBITDA or P/CF or EV/boe (EV/barrels of oil equivalent)
• Software Segment Valuation – We use PE or EV/EBIT multiple to value Software
Segment
• Bank Segment Valuation – We generally use P/BV or Residual Income Method to value
Banking Sector
• E-commerce Segment – We use EV/Sales to value E-commerce segment (if the
segment is not profitable) or EV/Subscriber or PE multiple

Football Field Analysis

A football field graph is a graph showing the valuation of a company according to different
methodologies. Some of the methodologies used are:
a) DCF
b) Public Comparables
c) Precedent Transactions
The graph will show the different mean valuations and multiples for the different
methodologies and allow the person who is conducting the valuation (or most likely their MD)
to decide which method to use primarily to achieve the best possible valuation.
Companies are valued using a combination of multiples and future cash flows, and each of
these can be taken in a best, worst and median case.

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For example, with a discounted cash flow, you could assume that the company will have a
terminal growth rate of x%, x+1% or x-1% and this would give 3 different final values.
Therefore, the discounted cash flow method will give a range of values for the company. This
applies to all valuation methods (you can trade at a high, low or average multiple of earnings
etc.). The best way to show this visually is using a graph, like the one shown below.

Enterprise Value
Enterprise Value, or EV for short, is a measure of a company's total value, often used as a more
comprehensive alternative to equity market capitalization. The market capitalization of a
company is simply its share price multiplied by the number of shares a company has
outstanding. Enterprise value is calculated as the market capitalization plus debt, minority
interest and preferred shares, minus total cash and cash equivalents. Often times, the minority
interest and preferred equity is effectively zero, although this need not be the case.

EV = market value of common stock + market value of preferred equity + market value of debt
+ minority interest - cash and investments.

Pictorial view of calculation of EV

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