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The Economic Times Value & Valuations 1

 Valuation is Valuation is Valuation can’t
Subjective Biased be Precise

The Economic Times Value & Valuations 2

 Characteristic 1: Valuation is subjective
It is subjective because valuation is subject to the assumptions a valuer is taking to value a particular
company or business.
✔ These assumptions can be different from one valuer to another. With change in assumption your
valuation will also change.

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 Characteristics 2: Valuation cannot be precise
There is no precise valuation.
• It cannot be precise as different assumption and different methods of valuation can lead to
different valuation.
• This is the reason we prefer quoting valuation in a range rather than giving a precise value.

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 Valuation methods

Asset Based Value Intrinsic Value (DCF) Relative Valuation

• Calculate value of • Calculate value of

• Value is decided on asset based on how
business or asset
the basis of realizable other similar assets
based on Cash flows
value of tangible are priced in the
it is expected to
assets in the business market
generate over its
• Used to value asset entire life
heavy business with
• discounted to the
no brand value
present value

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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:

Investing ▪ Investors perform a valuation of a stock before purchasing it to assess whether the price they are
paying aligns with the value they are receiving

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

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

Business Restructuring ▪ 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.

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

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 RELATIVE
VALUATION
The Economic Times Value & Valuations 7
 Relative Valuation
Comparable Public Companies Analysis
Comparable Precedent Transaction Analysis
✔ Here we try to find value of the asset based on how the market prices other similar asset. That’s why its
called relative valuation
✔ Multiples are compared. As absolute numbers are not comparable, we calculate multiples (a standardize measure of
value)
✔ Why do we need multiples?
• To identify under-priced/over-priced stock in the market; buy cheap, sell expensive
• To do the valuation of a Public or private company

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 Our goal here is to build a deeper understanding of:

A. What is Relative Valuation and Why is it Needed?

B. How to Perform Relative Valuation

C. Analyzing the Output of Relative Valuation

D. Valuing a Company Using Multiples Derived from Relative Valuation

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A. WHAT IS RELATIVE
VALUATION AND WHY IS IT
NEEDED?

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 ❑ Relative Valuation involves determining the value of a target company by comparing it to other similar
companies. In this approach, we estimate the implied value of the target company based on how similar
companies are priced in the market.
❑ This process is similar to valuing real estate, where a property is valued based on the prices of similar
properties in the market.
Since absolute values of companies or assets are difficult to compare directly, we first convert
these values into a standardized measure called a "multiple."
The multiples derived from this comparison serve as the basis for:
✔ Comparing the market price of similar companies or assets.
✔ Estimating the implied value of the target company or asset.

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 Let’s understand with an example of real estate…

❑ Let’s assume you want to sell your house located in Gurgaon, with a total area of 2,500 square feet.
You hire a real estate agent to determine the selling price.
After evaluating details about the house, such as location, size, and other factors, the agent
quotes a fair price of approximately INR 4,10,00,000.
But how did the agent arrive at this number? What valuation technique did they use to value the
house?
Did the agent perform an intrinsic valuation of the house?
The answer is no. The agent did not conduct an intrinsic valuation. Instead, the agent used a
relative valuation technique.

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 Let’s understand how real estate agent computed value of house

First, agent identified Similar type of real estate properties which are previously bought and sold. Say
he/she found following similar properties which are recently sold in the market.

House Area (in Sq Price (INR)

Feet)
A 2000 3,20,00,000
B 2200 3,69,60,000
C 2800 4,53,60,000
D 3000 4,98,00,000

In the above list we can see different houses previously being bought and sold in the market are of
different sizes. As units (i.e. area) of these houses are not same, we can not compare their absolute prices.

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 Real Estate Example Contd….
So in that case, agent have first converted absolute prices of these houses in to standardised measure of value say
Price/Square feet (as shown ).

House Area (in Sq Price (INR) Price/Sq Feet

Feet)
A 2000 3,20,00,000 16,000
B 2200 3,69,60,000 16,800
C 2800 4,53,60,000 16,200
D 3000 4,98,00,000 16,600

Maximum 16,800
Average 16,400
Minimum 16,000
Based on the comparison of price per square foot of similar properties, the agent found that houses similar to yours
have been previously bought and sold at an average price of INR 16,004 per square foot, with a minimum of INR
16,000 per square foot and a maximum of INR 16,800 per square foot.

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 Real Estate Example Contd….
Based on above multiple of Price/Square Feet, the real estate agent calculated approximate market value
of our target property which is

= 2,500 Square Feet x 16,400 = 4,10,00,000

Area of Price/Sq Feet of

House Comparable Houses

This is perfect example of relative valuation

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 Now let’s see how this technique works for companies...

Say we want to value a technology company XYZ Limited. Based on its business and other attributes, we found
following Listed Technology companies having similar characteristics as our target company XYZ Limited is having.

Company Per Share Price Earnings Per

Share
Dell $52.9 $5.5
HP Inc. $18.8 $2.3
IBM $140.6 $11.4

In the next Columns, we have information about their per share market price (as on valuation date) and Earning Per
Share.

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 Company Valuation Example Contd...
As we discussed in previous example, we can not compare absolute Share prices of these comparable companies, due
to difference in their earnings per share. Therefore we first have to convert prices of these companies into
standardised measure of value (as shown below)

Company Per Share Price Earnings Per Share Price / EPS

Dell $52.9 $5.5 9.6x
HP Inc. $18.8 $2.3 8.2x
IBM $140.6 $11.4 12.3x

Maximum 12.3x
Average 10.0x
Minimum 8.2x

On the comparison of Price/EPS (PE) multiple of similar companies in the industry, we found that companies similar
to our company XYZ Ltd., are priced at an average PE multiple of 10.0x in the equity market.

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 Company Valuation Example Contd...

Based on this average PE multiple of technology companies, we can calculate value of our target company XYZ Limited
as follows:
▪ Say Company XYZ earned Net income of $2,000 million last year.
▪ Implied market value of XYZ Ltd. based on other similar companies PE multiple would be

= 2,000 million x 10x = $20,000 million

Net Industry Average PE

Income of Multiple
XYZ

So friends in the above examples we have seen how Relative valuation technique can be used to value other similar
asset or company.

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 How Relative Valuation is Different From DCF?
❑ While DCF (Discounted Cash Flow) valuation is driven by your view on the company’s fundamentals, Relative
Valuation reflects the market's view on the industry and sector. The key assumption in Relative Valuation is that the
company you’re valuing should be priced in line with similar companies trading in the market.
❑ In DCF valuation, you make explicit assumptions about the company’s future, such as growth rates, risk factors, and
the cost of capital. In contrast, Relative Valuation involves implicit assumptions. These include:
▪ The assumption that all the companies you are comparing are identical in terms of their fundamentals.
▪ The assumption that the market has assigned a fair and justified valuation to the entire industry.

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 Do we get same value under both Intrinsic Valuation and Relative Valuation?

Though both these methods of valuation interconnected but they are not always going to give you same
value as basis of valuation is entirely different under both these techniques of valuation.
✔ Under intrinsic valuation, asset is valued based on its cash flows, growth rate and risk, whereas
✔ Under Relative valuation, value of asset is derived from how other similar assets are priced in the
market.

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B. How to Perform Relative
Valuation?

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 Relative Valuation– Process
Broadly Relative Valuation involves two steps

▪ Finding similar companies to compare; this is the hardest part of relative valuation as it is difficult to find
exactly same companies to compare. No two companies are identical. Even if they are operating in similar
business, they might be different in terms of growth, risk, return etc. Given this practical difficulty in finding
similar companies to compare, we try to reach as close as possible, depending upon availability of listed
companies in the same space.

▪ Standardising the price of companies; In this step, we standardise price of comparable companies by
converting their absolute market price into the multiples. This process is of paramount importance as we can’t
compare price of one company with other companies unless they are standardised.

For better understanding, we have detailed this 2-step process in to 7-step process in next slides.

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 Relative Valuation – 7 Step Process

• Selection of Comparable Companies listed in the Equity Market. The

Screening of Comparable
Step 1 companies companies we are comparing should be similar in terms of Business, Size
and Geography, to keep their fundamentals close to each other.

• Market Capitalisation is simply the total market value of all equity shares of
Step 2 Calculate Market Capitalisation the company
Market Cap = Per Share Market Price x No of Shares

• Enterprise Value (EV) = Equity value (Calculated in step 2) + All source of

Step 3 Calculate Enterprise Value
capital employed in the business, other than common Equity

• Most commonly used Financial Metrics are Sales, EBITDA, EBIT, NOPAT,
Step 4 Calculate Companys’ Performance FCFF, EPS etc.
Metrics • Operating Metrics such as No of Subscribers, No of Visitors, Ton Capacity,
No of beds in Hospital etc.

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 Public Companies Analysis – 7 Step Process

• In this step we will calculate multiples, a standardise measure of value, by

relating companies’ Market Value (Equity Value, Enterprise values) with its
financial or operating metrics (as calculated in step 4 above)
✔ Financial Metrics Based Multiple: EV/Sales, EV/EBITDA, EV/EBIT,
EV/NOPAT, P/E, P/BV, etc.
✔ Operating Metrics Based Multiples: EV/Subscribers, EV/Ton Capacity,
EV/No of Beds etc.

Calculate multiples • While calculating multiples, we should to make sure that values we are relating
Step 5 should make sense i.e. it should be apple to apple comparison of values in
numerator vs denominator.
✔ For example it make sense to relate equity value with EPS as both number
belongs to equity, but we can’t relate EV to EPS as EV belongs to entire
firm whereas EPS belongs to equity holders.
✔ Likewise it make sense to relate EV with EBIT and EBITDA as both numbers
belongs to firm, but it does not make sense to relate EV with EPS as one
belongs to firm and another belongs to equity.

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 Public Companies Analysis – 7 Step Process

• Median, 25th and 75th Percentile of all comparable companies’

multiples as calculated in Step 5 above
Calculate Industry Benchmark • These Industry multiple Indicates where market consensus lies about
Step 6 Multiples valuation of an industry. For Example. we can say that in IT sector,
average industry PE multiple is 10x or as per market, IT industry is priced
10x times to its earning.

• Compute Implied Enterprise and Equity Value of target company based

on Industry Benchmark multiples calculated in step 6 above
Step 7 Calculate Implied Value of Target
Company. • We can use this technique to value both Public as well as private
Companies

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 Implied Assumptions in Relative Valuation
Like other techniques of valuation, In Relative Valuation also we need to deal with assumptions. In DCF valuation these
assumption are explicit whereas in Relative Valuation they are implicit.

Implied Assumption 1: One of the major implicit assumption is that all comparable companies are having same
fundamentals (i.e. they are exactly same in terms of business, product, risk, growth etc.). In case this
assumption doesn’t hold up, valuation can be drastically affected.
Implied Assumption 2: While comparing individual companies’ pricing multiples with industry average, we are
assuming that the market is correct at average but may be wrong at individual company pricing.

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Step 1 Screening of Comparable companies
Under this step we will build list of Companies
✔ Which are listed in the Equity market, and
✔ Comparable to our Target Company, Dr Pepper
This is most important part of Relative Valuation , as if our comparable companies are not defined correctly, the
resulting value of target company would also be incorrect.

While doing initial screening of comparable companies, we normally select these companies on the basis of
following key parameters:

1. Geography: Comparable companies’ geography of operation should be same or close to our target
company
2. Sector and Industry: while choosing comparable companies, we pick companies from Sector and
Industry which closely resembles to Sector and Industry of our target company
3. Size: to keep fundamental of companies close to our target companies, we also make sure that size of
comparable companies is also close to our target company. Size of companies can be defined on the
basis of its market Capitalisation or Revenue.

. Times
The Economic Value & Valuations 27
 In addition to these three parameters, you can apply other factors based on the variations in the fundamentals of
comparable companies relative to our target company.
After conducting an initial screening of comparable companies using the above parameters, we can refine the list
further by delving deeper into their business models, product portfolios, and other relevant aspects.
It’s important to note that the precision with which we define comparable companies depends on the availability
of a sufficient number of listed companies within the target company’s sector. If there are enough listed
companies in the same space as the target company, we can define the comparables with greater accuracy.
However, if the number of listed companies is limited, we may need to make compromises in the precision of our
selection.

Databases to source list of comparable companies:

There are various databases we can use to extract list of comparable companies.

✔ Paid databases like Capital IQ, Thomson One etc.

Or
✔ In case we don’t have access to paid databases, we can use databases which are available freely like: Finviz,
Marketscreener, Yahoofinance, Googlefinance.

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 Step 2 Calculation of Market Capitalisation

Market Capitalisation is the total value of all outstanding shares of the company. It is also referred as Market
Cap. Market Cap is calculated by multiplying market price per share by the number of shares outstanding of
the company.

Market Cap = Market Price Per Share x Number of Shares Outstanding

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 Market Cap Market Price Per Share Number of Shares Outstanding

✔ Market price is the price at which stock of the company is trading in the Equity Market

✔ Source of Information: Can be sourced from various market portal like: Bloomberg, Capital IQ,
Marketscreener.com, Googlefinance.com, investing.com etc.

✔ Price should be closing market price on the date of valuation. Say if we are doing valuation on 21 st Nov 2024,
Market price of shares should also be of 24th Nov 2024 of all comparable companies.

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 Market Cap Market Price Per Share Number of Shares Outstanding

Total Shares Issued by

Treasury Shares
the Company

Includes all shares issued by the ✔ Treasury shares are netted off, as these
company to different types of treasury shares do not carry any value
stakeholders in the company, say: ✔ These shares do not have any voting
✔ Promoters of the Company and dividend rights
✔ Institutional Investors (FIIs/DIIs) Note: If the company has directly reported
✔ Retail Investors shares outstanding, don’t adjust treasury
✔ Company Itself shares as they are already adjusted

*Source of Shares Outstanding Information: We can source shares outstanding information from Company’s filing

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Step 3 Calculation of Enterprise Value

Enterprise Value is the value a buyer would pay for the business independent of its capital structure.

✔ Enterprise Value is more comprehensive measure of value than Equity value as it looks at all component
of capital invested in the business rather than just the Equity Value

✔ It doesn’t matter how business is financed; its Enterprise value stays the same. Lets understand this with
help of an example.

The Economic Times Value & Valuations 32

Let’s assume you are buying a house worth of $800 thousand. Regardless of how you pay for this house does not affect
total value of the house. There can be various structure of financing this house, say

Case 1 Case 2 Case 3

Equity (Own Fund): 25% Equity (Own Fund): 50% Equity (Own Fund): 75%
Debt: (Outside Fund): 75% Debt: (Outside Fund): 50% Debt: (Outside Fund): 25%

Equity
$200K Equity
Total $400K Total Equity
Total
Cost Cost $600K
Debt Cost
$800K $800K Debt $800K
$600K
$400K Debt
$200K

In all above cases, total value of house remains same i.e. $800 thousand, but value of equity and debt is changing
depending upon how you are financing your house.

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 Enterprise Value (EV)

Non Controlling Preferred Cash &

Enterprise Value Market Cap Total Debt
Interest Stock Equivalents

“What is the full Outstanding Includes Short

capital used to shares term debt, long
fund my entire multiplied by term debt,
business / current market debentures,
enterprise” price bonds, senior
notes

Also Known as Net Debt

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 Non Controlling Interest

Non Controlling Interest (minority interest): means that portion of subsidiary company not owned by holding company.

Subsidiary Co.

(Owned By)

80% 20%
HoldCo. Other Shareholders
(Holding Company) Minority Shareholders

In the balance sheet of Holding Co, remaining 20% stake in subsidiary company not owned by Holding company would
be shown as Minority Interest.

The Economic Times Value & Valuations 35

The question is why do we add minority Interest in calculation of Enterprise Value?
✔ As per accounting rules, when a company owns more than 50% equity of another company, that another
company becomes subsidiary of that company.
✔ In this situation, holding company is required to consolidate 100% of all assets, liabilities, revenue, expenses, cash
flows etc of subsidiary company in its financial statement.
✔ It means all the firm (i.e. EV) level financial metrics such as Sales, EBIT, EBITDA, NOPAT, FCFF of holding company
includes 100% Sales, EBIT, EBITDA etc. of subsidiary company.

Minority

100% of Holding + 100% of

Subsidiary
Consolidated
Holding

Subsidiary

The Economic Times Value & Valuations 36

 Example of Consolidated Income Statement

✔ In this example we can see line by line item consolidation of Income Statement. At the bottom of the consolidated income statement,
Share of Minority interest from consolidated net income has been adjusted to calculate Net income available to common shareholders
of holding company.

✔ In the given example, minority’s claim on consolidated net income is equal 20% of net income of Subsidiary Co (S) and balance is
available to the shareholders of holding co.

The Economic Times Value & Valuations 37

 While calculating Enterprise Value based valuation ratios (e.g. EV/Sales, EV/EBITDA);
✔ Sales or EBITDA would include 100% of Sub’s Sales or EBITDA even thought holding company does not own 100% of
Subsidiary.
✔ In order to counteract this, we add value of subsidiary company that holding company does not own (i.e. Minority
Interest) to balance both numerator and denominator.

EV = Market Cap + Minority Interest + Pref Stock + Total Debt - Cash & Cash Equivalent

Reflecting
100% equity Value of Consolidated numbers which reflects
value of remaining
20% equity of 100% of Holding + 100% of Subsidiary
Holding and
80% equity subsidiary co.
value of
subsidiary co.

100% of Holding + 100% of Subsidiary

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 Apples
EV 100% Capital of Holding Co. + 100% Capital of Subsidiary Co.
= Vs
Sales 100% Sales of Holding Co. + 100% Sales of Subsidiary Co. Apple

In above valuation multiple, both numerator and denominator include 100% of subsidiary, and we have consistent
multiple

The Economic Times Value & Valuations 39

 Proffered Stock

Preferred Stock are hybrid securities sharing features of both equity and debt.

✔ They are treated more as debt, because of their fixed dividend right and higher priority in asset and earning
claims than common stock.

✔ In an acquisition, they normally must be repaid just like debt.

✔ In case preferred stock is listed, market price can be taken otherwise book value of preferred stock can be
taken as proxy of market value.

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 Market Value of Debt

Includes all interest-bearing obligations of the company whether long term or short term.

Market value is preferred but In case market value of debt is not available, book value of debt can be taken as proxy
of market value of debt.

✔ In case of healthy co, variation in market value and book value of debt would not be material.

✔ However, in case of company, which is at the brink of bankruptcy, there can be substantial difference in market
value and book value of debt. in this situation, market value of debt would be much lower than the book value
of debt.

Note: Debt does not include liabilities like creditors for the simple reason that creditors have not provided any
capital to the business and, they don’t have any claim on earnings of the business. In fact, the liability towards them
is from the operations of the business i.e. for the goods supplied by them.

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 In case required, we can estimate market value market value of debt using the interest expenses, average maturity on
the debt and current cost of debt of the company

1 FV
Market value of debt = Coupon Payment x 1- +
( 1+ Kd )^t ( 1+ Kd )^t
Kd

Where,
Coupon Payment = Annual Interest Payment
Kd = Current Cost of Debt of company
t = average maturity period
FV = redemption value of debt

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 Cash & Cash Equivalent

It is most liquid asset of the company in form of cash, marketable securities, commercial papers etc.
✔ Logic of subtracting cash & cash equivalent amount from EV is to calculate total capital being utilised in the
operation of the company.
✔ It is sort of unutilised fund in the business which should be netted off to calculate value of total capital
employed in the business.
✔ From acquisition prospective, it is assumed that acquirer will use this amount to pay off portion of its
takeover price. Specifically, it can be used to pay off debt amount of target company.

Net Debt

It assumes that when a company has been acquired, the acquirer can use target company’s cash to pay part of
assumed debt of target company.

Net Debt = Total Debt – Cash & Cash Equivalent.

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 Operating EV

Operating EV is refined version of EV

Operating EV means total capital employed in the core operation of the company.

Operating EV = Market Capitalisation + Minority Interest + Preferred Shares + Market Value of Debt - Cash and Cash
Equivalent - Non-Operating Assets the Business
Or
Operating EV = EV – Non-Operating Assets in the Business

✔ Just like cash and cash equivalent, non-operating assets are also subtracted from EV to calculate operating EV.

✔ Here logic of subtracting non-operating asset is, these non operating assets does not contribute anything to the
operating earnings of the business.

✔ Even If company gets any earnings from these non-operating assets, those earnings are always reported below
EBIT /Operating Earnings.

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Step 4 Calculation of Company’s Performance Metrics

Under this step we would calculate Financial and Operating Metrics of the Company, which are key indicators of its performance

Performance Indicators

Financial Metrics Operating Metrics

Example of Financial Metrics Example of Operating Metrics

used to measure performance used to measure performance
of the company of the company

■ Revenue ■ No of Subscribers

■ EBITDA ■ No of Visitors on Website

■ EBITA ■ No of Beds in Hospital

■ EBIT ■ Ton Capacity of a Cement

Plant
■ NOPAT
■ Mega Watt Capacity of
■ Net Income Power Plant
■ Free Cash Flows

The Economic Times Value & Valuations 45

 Note 1:
These Performance Metrics are key value drivers of the company

(i.e. Market Cap and Enterprise Value of comparable companies, we calculated under step 2 and step 3, is driven by performance of
companies on the front of key financial or operating metrics discussed above)

Under Next step (i.e. Step 5), we will use these metrics to standardise Equity and Enterprise Value of comparable companies, so that
we can compare them.

Say,

EV/Sales, EV/EBITDA, EV/EBIT, EV/NOPAT, Market Cap/Net Income (i.e. P/E) etc.

The Economic Times Value & Valuations 46

 Note 2: Latest Twelve Months and Forward Financials

Multiples are Calculated Based on

Latest Twelve Months

Forward Financials
Financials (LTM)
Also Known as Trailing
Twelve Months (TTM)
These are market consensus
estimates about future years
financial performance of the
These are 12 Months
company
financials reported by the
company latest up updation
date (i.e. date of valuation)

The Economic Times Value & Valuations 47

 Lets try to understand calculation of Latest Twelve Months (LTM) numbers with help of an example:

Suppose we are required to calculate LTM Sales of a Company XYZ Ltd. Key details are:

Updation Date: 26 Feb 2018

Latest Financial reports published by XYZ Ltd as on updation date are

Case 1
Filing Type Filing Date Filing Period No of Months Revenue
Annual 3rd March 2017 1 Jan 2016 to 31 Dec 2016 12 Months USD 6,500mn
Quarterly 6th Dec 2017 1 Jan 2017 to 30 Sep 2017 9 Months USD 5,800mn
Quarterly 6th Dec 2017 1 Jan 2016 to 30 Sep 2016 9 Months USD 4,500mn

Case 2
Filing Type Filing Date Filing Period No of Months Revenue
Annual 20th Feb 2018 1 Jan 2017 to 31 Dec 2017 12 Months USD 7,000mn
Quarterly No Quarterly filing was published between Annual filing and updation Date

The Economic Times Value & Valuations 48

Lets Calculate LTM Revenue for Case 1

LTM Results

Reported Fiscal Year- annual

report

Q1 Q2 Q3 Q4 Q1 Q2 Q3

Reported previous year Reported accumulated current year

accumulated 9 month results 9 month results

(Prior stub) (Current stub)

Annual Current Stub Prior Stub LTM Revenue

LTM Revenue of XYZ Ltd = 6,500 + 5,800 - 4,500 = USD 7,800mn

The Economic Times Value & Valuations 49

 Lets Calculate LTM Revenue for Case 2

LTM Revenue of XYZ Ltd

=
Reported Fiscal Year- annual
report Annual 7,000
+
Current Stub NIL
Q1 Q2 Q3 Q4 -
Prior Stub NIL

LTM Results
=

LTM Revenue USD 7,000mn

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 Source of Information for LTM Financials

1. Latest Annual Report

2. Latest Quarterly Report (in case company has published quarterly report post latest annual report)

Source of Information for market consensus estimates about future years financial performance of the company

We can source this information from various research databases like

• Capital IQ

• Bloomberg

• MarketScreener

The Economic Times Value & Valuations 51

 Note 3: Clean Financials

❑ Clean financial statements to find out the true financial position and profits of a company. Adjustments are made to nullify the effect of
exceptional income/expense items on the P&L of the company

(under this step we reverse impact of exceptional / non-recurring items from reported financials of the company)

❑ Calculation of adjusted (clean) numbers of peer group companies are of paramount importance.

(If financials of the company are not cleaned, they will present distorted picture of company’s financial performance and accordingly
multiple calculated on the basis of these distorted financials will also be distorted and non comparable)

Lets understand this with the help of an example….

The Economic Times Value & Valuations 52

 XYZ Ltd. Has reported EBIT for Fiscal Year Ending 31 Dec 2017 USD 1,500mn. Reported EBIT for the year is after considering impact of
following items:

▪ Restructuring charges: USD 500mn

▪ Goodwill impairment charges: USD 1,200mn

▪ Gain on sale of assets: USD 200mn

▪ Increase in cost of good sold due to increase in raw material cost: USD 600mn

Enterprise Value of XYZ Ltd as on updation date is : USD 30,000mn

Calculate EV/EBIT Multiple for XYZ Ltd.

First lets calculate clean financials of XYZ Ltd

Reported EBIT 1,500

Adjustment of exceptional
income/expenses
Add: Restructuring Charges 500
Add: Goodwill impairment charges 1,200
Less: Gain on sale of assets (200) 1,500
Adjusted EBIT 3,000

The Economic Times Value & Valuations 53

 Now lets calculate EV/EBIT multiple on the basis of both reported and clean EBIT

Reported Clean
EV 30,000 30,000
EBIT 1,500 3,000

= =
20X 10X

The Economic Times Value & Valuations 54

 Sample List of exceptional Items of Income and Expense

✔ Restructuring Cost

✔ Impairment cost of tangible and intangible assets

✔ Mark to market gain/losses on investments

✔ M&A transaction related cost, say integration cost, transaction expenses etc.

✔ Cost of divestitures

✔ Gain/(Losses) on sale of assets

✔ Loss due to early retirement of debt

✔ Gain/(Losses) related to legal matter

✔ Settlement charges

✔ Gain/(Losses) from discontinued operation

✔ etc.….

The Economic Times Value & Valuations 55

Step 5 Calculation of Multiples

❑ In this step we will calculate multiples, a standardise measure of value, by relating companies’ Market Value (Equity
Value, Enterprise values) with its financial or operating metrics (as calculated in step 4 above)

▪ Financial Metrics Based Multiple: EV/Sales, EV/EBITDA, EV/EBIT, EV/NOPAT, P/E, P/BV, etc.
▪ Operating Metrics Based Multiples: EV/Subscribers, EV/Ton Capacity, EV/No of Beds etc.

❑ While calculating multiples, we should to make sure that values we are relating should make sense i.e. it should be
apple to apple comparison of values in numerator vs denominator.

▪ For example it make sense to relate equity value with EPS as both number belongs to equity, but we can’t
relate EV to EPS as EV belongs to entire firm whereas EPS belongs to equity holders.
▪ Likewise it make sense to relate EV with EBIT and EBITDA as both numbers belongs to firm, but it does not
make sense to relate EV with EPS as one belongs to firm and another belongs to equity.

The Economic Times Value & Valuations 56

Step 6 Calculation of Industry Benchmark Multiples

Under this step we will calculate industry benchmark multiples on the basis of comparable companies’ multiples
calculated in step 5

✔ Median or Average of all comparable companies’ multiples as calculated in Step 5 above

OR

✔ 25th and 75th Percentile instead of Median as Industry benchmark multiple

These Industry multiple Indicates where market consensus lies about valuation of an industry. For Example. we
can say that in IT sector, average industry PE multiple is 10x or as per market, IT industry is priced 10x times to
its earning.

The Economic Times Value & Valuations 57

 Output-Comparable Companies Analysis

The Economic Times Value & Valuations 58

C. ANALYZING THE OUTPUT OF
RELATIVE VALUATION

The Economic Times Value & Valuations 59

 Analysis of multiples

Selection of appropriate multiple for comparison and valuation

Fundamentals (Key Variables) and Their Impact on Multiples

The Economic Times Value & Valuations 60

 Why multiples vary?

The Economic Times Value & Valuations 61

 Before we jump to analysis of multiples calculated on output sheet, we are required to understand possible reasons for why multiples of
comparable companies vary from each other. There could be three possible reasons for variation in multiples of comparable companies

1. Differences in quality of the business

2. Mispricing

Now lets understand these differences in detail and how to deal with them.

The Economic Times Value & Valuations 62

1. Differences in quality of the business

❑ Business having stronger fundamentals deserves higher multiple than its peers.

❑ Key fundamental drivers making differences in the multiple are:

▪ Cost of capital: firm having lower cost of capital due to lower risk would deserve higher multiple and vice versa.

▪ Return on capital: firm having higher return on capital would deserve higher multiple and vice versa

▪ Growth: firm having higher growth in its future earnings deserve higher multiple in current market and vice versa

❑ We try to keep fundamentals of comparable companies as close as possible by putting filters at the time of selection of comparable
companies (Industry, geography, size etc.)

The Economic Times Value & Valuations 63

 ❑ Still there can be some differences in fundamentals of the companies, then how to allow these fundamental differences in the multiples?

▪ We can deal with these fundamental differences in comparable companies in following ways:

I. Adjusting multiples for difference in fundamentals by

✔ Dividing multiples with variable affecting multiples (e.g. PE/G, EV-EBITDA /G, EV-Sales/Margin)

✔ Running regression on multiples against fundamentals of comparable companies

II. Classifying industry multiples in Quartile 1 (25th Percentile), Quartile 2 (Median) and Quartile 3 (75th Percentile) and
selection of appropriate multiple for the target company by matching its fundamentals with these different categories of
industry multiples.

The Economic Times Value & Valuations 64

 2. Mispricing

If difference in multiple is not fully explained by differences in business quality as discussed above in that case stock may be simply
mispriced.

The Economic Times Value & Valuations 65

SELECTION OF APPROPRIATE
MULTIPLE FOR COMPARISON AND
VALUATION

The Economic Times Value & Valuations 66

 EV/Sales

❑ EV/Sales is a crude measure, but least affected by accounting differences.

▪ It’s a crude measure as it does not capture picture of profitability of the comparables.

▪ In the Income Statement, sales is the least affected number by accounting differences. Reason being sales comes at the top of
Income statement and more you stay at the top of income statement less would be impact of accounting differences.

When to Use When Not to Use

✔ Where profit or cash flow numbers are unrepresentative or ✔ Not good measure to compare for industry where profits are
negative. key value drivers

Conclusion:

▪ EV/Sales measure is frequently applied for initial growth phase companies having negative and volatile earnings and cash flows such as
technology firms.

The Economic Times Value & Valuations 67

 High Growth Technology firms where earning based multiples does not work…

▪ In above comparison, we can not compare earning based multiples such as EV/EBITDA, EV/EBIT or PE as they are not
presenting meaningful picture of comparison, due to negative earnings of most of companies.

▪ The only multiple which is making sense here is, EV/Sales multiple.

The Economic Times Value & Valuations 68

 EV/EBITDA

▪ EV/EBITDA is more complete measure than EV/Sales as it captures picture of profitability of comparables, but slightly more affected
by accounting differences.
▪ Not affected by asset step-ups and Identified Intangible assets
✔ At the time of acquisition, acquirer revalue target company’s assets (generally on upper side) and liabilities. Also it recognize
identifiable intangible assets in the balance sheet. This step up of assets and identification of intangible assets results in significant
amount of additional depreciation and amortization.
✔ Therefore, in comparison of peers, the company which has grown by acquisitions will have much more depreciation and
amortization expense than other comparable company which has grown organically.
✔ The acquisitive Company’s EBIT and Net Income will be understated compared to organically grown company resulting in artificially
higher EV/EBIT and P/E multiples whereas EV/EBITDA multiple will be unaffected as depreciation and amortization expense is
added back.
▪ Not affected by differences between depreciation and amortisation related accounting policies
✔ In calculation of D&A expense, companies make judgement about useful life of tangible and intangible assets. This flexibility in
making estimation about useful life of assets may result in significant variation in the amount of D&A expense of comparable
companies. Companies estimating shorter life of assets would report higher amount of D&A expense compared to other companies
in the same sector. Also, there are various methods available for calculation of D&A expense.
✔ EBIT and Net Income can be distorted by such accounting policy differences where EBITDA will not.
✔ For example, Telecom is a capital-intensive sector. On the next slide we are comparing estimated life of assets by AT&T and
Verizon Communications.

The Economic Times Value & Valuations 69

 Verizon Communications

AT&T

The Economic Times Value & Valuations 70

 When to Use When Not to Use
✔ Useful in comparing companies in capital intensive sectors such ✔ In case there is large variation in capital intensity of peer group
as Telecom, Oil & Gas, Cement and Energy sector companies, EV/EBITDA measure may paint misleading picture of
relative valuation.
✔ Works well for valuing companies where the gestation is too long
such as Telecom sector ✔ For example Aviation sector where we can have significant
difference in capital intensity of Comparable companies. Here
instead of EBITDA, we can use EBITDAR or EBIT and better
comparable measures

The Economic Times Value & Valuations 71

 Below is the comparison of fleet composition of Delta Airlines and Southwest Airlines
Delta Airlines

The Economic Times Value & Valuations 72

 Southwest Airlines

The Economic Times Value & Valuations 73

 EV/EBIT

EBIT is better proxy of free cash flow than EBITDA as it also consider impact of maintenance capex (i.e. depreciation and amortisations exp).
However EBIT is more exposed to accounting differences than EBITDA as D&A is one of the most affected item by accounting differences.

When to Use When Not to Use

✔ Useful in comparing peer group companies where capital ✔ In case there is large variation accounting treatment of
intensities differ, such as retail firms depreciation and amortisation expenses among comparables.

The Economic Times Value & Valuations 74

 Price/Earning (PE)

❑ It is an equity based multiple. Compared to EV multiples, equity multiples are less comprehensive as it covers just part of the total
business valuation.

❑ PE multiple is exposed to many distortions, such as:

▪ Accounting differences

▪ Capital structure differences

▪ Non operating activities of the business

When to Use When Not to Use

✔ In case of banking and financials companies, as we can ✔ If we have EV based multiples available, in that case
not use EV based multiples for these companies. prefer not to use this multiple in isolation as it can paint
misleading picture of relative valuation due to reasons
✔ For other industries, we can use this multiple along with
discussed above.
other multiples such as EV/EBITDA or EV/EBIT but not in
isolation.

The Economic Times Value & Valuations 75

 Price/Book value (PB)

❑ Price to book value is a useful measure where tangible assets are the source of value generation in the business.

❑ This ratio is more useful measure for banking and financial company where earnings are directly related to their assets, which are
mostly in liquid form.

The Economic Times Value & Valuations 76

 EV/Operating Metrics

❑ Instead of financials performance metrics, we can also relate value of the businesses with its Operating Metrics.
❑ In case when financial number do not make sense (WhatsApp and Facebook deal, where financials of WhatsApp were not important
rather the deal was based on active user base of WhatsApp) we will use operating drivers of value .
❑ At some point in time in future company need to convert those operating drivers into financial numbers. Subscribes/ Visitors etc. need to
generate profits for company. So when company is not a young company anymore we should be using financial multiples. ( Operating
multiples can also be used as complement to financial multiples )
❑ Operating Driver of value for different industries could be different sources for example for
▪ New age tech company (Infoedge) driver of its value could be number of users of their services
▪ Steel Company (Tata Steel) driver of its value could be production capacity
▪ For FMCG companies (HUL) driver of its value could be number of distributors
▪ For mining companies(Hindalco Industries) driver of its value could be total tonne of metal resource
▪ For banking companies (Kotak Mahindra bank) driver of its value could be number of branches

The Economic Times Value & Valuations 77

 When to Use When Not to Use
✔ Where financial indicators are unrepresentative ✔ Ultimately market value of business is determined by economic
value it creates and not by capacity it has. So in case financial
metrics are more representative of performance of companies in
the industry, we should not use operating metrics based multiples
in isolation.

The Economic Times Value & Valuations 78

 Our goal here is to build a deeper understanding of:

A. What is Relative Valuation and Why is it Needed?

B. How to Perform Relative Valuation

C. Analyzing the Output of Relative Valuation

D. Valuing a Company Using Multiples Derived from Relative Valuation

The Economic Times Value & Valuations 79

D. VALUING A COMPANY USING
MULTIPLES DERIVED FROM RELATIVE
VALUATION

The Economic Times Value & Valuations 80

 Step 7 Calculation of Implied Value of Target Company

Under this step we will calculate implied value of our “Target Company”, the company we want to value, on
the basis of industry multiples calculated in step 6 above.

✔ Selection of appropriate multiples

[here we will select appropriate multiples as per industry and situation (as discussed above in analysis
of multiple part)]
✔ Compute Implied Enterprise and Equity Value of target company based on Industry Benchmark
multiples
✔ We can use this technique to value both Public as well as private Companies

The Economic Times Value & Valuations 81

DCF VALUATION
Intrinsic Valuation

The Economic Times Value & Valuations 82

 DCF Valuation
(Intrinsic Valuation)
✔ Present Value of future cash flows we are expecting to generate from assets/business over its entire life

✔ Market price of the stock of the company is not intrinsic value of the company. It may be more than, less than or
equal to intrinsic value of the company as one is price and other is value and both may be different

✔ There is no surety that the price of the listed stock will come around its value. It may and may not. Longer
your investment horizon, greater are the chances of price coming around value of the stock but no surety. So don’t try to play short
term price and value difference game.

The Economic Times Value & Valuations 83

 Discounted Cash Flow
❑ DCF valuation, also called intrinsic valuation, is a technique under which Investment bankers/finance professionals try to value a
company based on its future cash flows.

❑ Broadly process of DCF valuation involves following 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 Value calculated above is different from relative value of the company derived using trading comps or precedent transaction
technique. Bankers use DCF valuation to check the valuation they are getting under relative valuation technique which might be
distorted by existing abnormal or extreme situations in the market.

The Economic Times Value & Valuations 84

 DCF Valuation –FCFF/WACC
Free cash flow Discounted to PV of Non
MV of Minority DCF Value
to firm (FCFF) calculate PV of FCFF Terminal Operating
Net Debt Interest of Equity
Value (TV) Asset

Earnings Before Interests Cost of Debt (Kd) PV of TV = TV/(1+WACC)n

and Taxes (EBIT) X
(1-Tax Rate)
X
Taxes on EBIT Weight of Debt (D/V) Exit Multiple Perpetual Growth
Method Method
TV = EBITDA of TV = FCFF1/(WACC-g)
Terminal Year x
Cost of Equity (Ke) EV/EBITDA Multiple
Non Cash Charges and
Earnings
Risk Free Rate (RF)
+
Beta (β)
X
Capital Expenditure
Market Risk Premium
(MRP)
X
Weight of Equity (E/V)
Change in Working Capital

FCFF WACC

The Economic Times Value & Valuations 85

DCF Valuation – FCFE/Ke
Discounted to PV of Non
Free cash flow to firm (FCFFE) calculate Minority DCF Value
Terminal Operating
PV of FCFE Value (TV) Asset Interest of Equity

Cost of Equity (Ke)

FCFF PV of TV = TV/(1+Ke)n

Risk Free Rate (RF)

+
Interest x (1-Tax Rate) Beta (β) Exit Multiple Perpetual Growth
X Method Method
Market Risk Premium TV = FCFE1/(Ke-g)
(MRP) TV = EBITDA of
X Terminal Year x
Net Change in Debt EV/EBITDA Multiple

FCFE Ke

The Economic Times Value & Valuations 86

 DDM Valuation – Dividend/Ke

Projected Dividend Discounted to calculate DDM Value

PV of Terminal Value (TV)
PV of Dividends of Equity

Projected EPS Cost of Equity (Ke)

PV of TV = TV/(1+Ke)n

Risk Free Rate (RF)

+
Projected Pay-out Ratio Beta (β)
Perpetual Growth Method
X
TV = D1/(Ke-g)
Market Risk Premium
(MRP)
In growth declining phase X
gradually increase Pay-out Weight of Equity (E/V)
ratio to reach target
pay-out ratio in maturity
stage

Target pay-out ratio in Ke

maturity stage = 1-matured
growth/ROE at maturity
stage

Projected Dividend

The Economic Times Value & Valuations 87

PROJECTIONS

The Economic Times Value & Valuations 88

 We can split forecast period in two or three phases depending upon growth phase of the business.

Phase I: It’s a high growth period of the company. During this period company grows at a rate higher than the steady growth rate of the company.
size of this period varies from 5 years to 0 years depending on business lifecycle of the company. For this phase we forecast detailed business plan.

Phase II: During this period company’s growth start moderating due to increase in competition and size of the company. This period start from end of
high growth period and end at the start of steady growth phase of the company. This phase usually extend up to 5 years.

Phase III: This is steady growth phase of the company. During this phase, company grows at a steady rate during its remaining life which in most of
the cases extend up to infinity. We don’t project this phase but capture the value of cash flow by calculating terminal value. The terminal value
represents the value of future cash flows generated by the company in the years after the detailed/extended forecast period.

Forecast Period Phase I Phase II Phase III

Detailed Projection Extended Projection Period Terminal Value

CF1, CF2,CF3….CFn CFn+1, CFn+2,….CFm CFm+1/(r-g)

Discounting with appropriate risk-equivalent discount rate

The Economic Times Value & Valuations 89

 Free Cash Flow
Now lets understand the process of DCF valuation discussed above in detail

Step I Projection of free cash flows

Free Cash Flows

Cash flows available for distribution amongst stakeholders /capital providers of the company after meeting reinvestment requirement of the business.

Free cash flows to Firm = Earning to Firm (net of tax) – reinvestment required in the business

EBIT (earning before interest and tax) XXXXX

Less: Taxes on EBIT XXXXX

Firm Earning Net of Tax / Unlevered Earning XXXXX

Add: Depreciation & amortisation Exp. XXXXX

Less: Capital Expenditures XXXXX Reinvestment in

the Business
Less/Add: Change in Working Capital XXXXX

FCFF (free cash flows to firm) XXXXX

The Economic Times Value & Valuations 90

 EBIT (Earning before Interest and Tax)

Revenue

Less: Operating Expenses

Revenue Projection

❑ Projecting revenue is the first and most important step of any projection. All projections of company’s financials starts with revenue
projections

❑ In Revenue projection, we first need to decide about projection period (i.e. for how long we want to do explicit projection).

✔ While doing valuation, we usually assume that life of the company, being a going concern, is infinite. Infinite life means
operation of the company will go on forever. However we do explicit projections only for high growth period (i.e. period before
maturity stage).

✔ For remaining period (i.e. period of steady growth) we can find value of cash flows by applying perpetuity method.

[we are required to project cash flows of the company up to the stage of maturity. On reaching maturity stage, we don’t
require any further explicit projections. We can simply calculate terminal value using perpetuity formula. The only condition to
apply perpetuity formula is steady growth rate.]

The Economic Times Value & Valuations 91

 ❑ Steady growth state

✔ Company’s growth rate falls to a level which it can sustain forever. We usually assume this growth rate close to economic
growth rate.

✔ Return on new capital investment falls down close to or equal to WACC. In other words, size of alpha (difference between
actual return and minimum required return) declines or becomes zero.

❑ Usually in model, we do explicit projections of the company for 5-10 years (i.e. we assume that company would reach steady
growth stage in 5- 10 years time period.

Basis of this 5-10 years projection period assumptions are:

✔ If we observe growth trend of the companies listed in the market (listed because we can easily access their historical data),
we will find that most of the companies’ growth get saturated in the span of 5 to 10 years.

[However there are companies in the market which could sustain high growth for extended period. But these companies are
exception now ( company like Google, Microsoft, Infosys).They have done awesome in past and have multiplied wealth of
their early stage investors many times. However assuming every company we are valuing is going to become exception is
not realistic assumption.]

✔ Possible reasons for “why it becomes difficult for the company to sustain high growth rate for extended” are as follows

o As the company grows, company’s size increases. It is difficult for the company to achieve same high growth on the
increased size which it achieved on small size. So gradually-gradually growth declines due to base effect.

o Increased competition unless there are high entry barriers for new players

The Economic Times Value & Valuations 92

❑ Extended projection period (Projection beyond 10 years): If we are doing valuation of pretty young company, we can assume
extended high growth period, provided we have strong reasons to believe that company can sustain high growth period for extended
period and it will not be justified to limit this to 5-10 years. Characteristics of such type of companies can be:

✔ Operating in niche industry

✔ Has proven and tested business model

✔ High entry barriers due to technology, regulatory, or capital intensity of the business

❑ Shorter projection period: If company is already matured or maturing fast, then its not necessary to project even 5 or 10 years.

✔ If its already matured then no projection is required and we can calculate terminal value at year 0.

✔ If its maturing fast then might consider limiting projection period from 3 to 5 year depending upon growth potential of the company.

The Economic Times Value & Valuations 93

 From above discussion, we can conclude that projection period for a company is dependent upon growth stage the company is right now. If
its already matured then no projection is required and if its pretty young company, we might consider extending company projection period
beyond 10 years.

However, Its always recommended to be slight conservative on high growth period and don’t go over board, as DCF valuation is entirely
projection based valuation and very sensitive to high growth period. Therefore taking high growth period beyond reasonable time period will
increase risk of overvaluation under DCF.

❑ Historical financials: Analysis of historical financials plays important role in projections. They will provide base for future projections.
Historical numbers will give us good insight about the company, say what growth stage company is into right now, its profitability, its
operational efficiency etc. In case of a new company with no precedent financial performance available, we can look at trends in
historical financials of its peer group companies.

Steps to follow

✔ Download historical financial reports either from company website or from regulatory authority’s website.

✔ Input financial statements (Income statement, balance sheet, cash flow statement) in your excel model

✔ Realign historical numbers, if required

✔ Clean up the numbers for extraordinary or exceptional items to get clear trend

✔ Calculate trends and ratios: revenue CAGR, expense ratios to revenue, profit margins, turnover ratios etc.

The Economic Times Value & Valuations 94

❑ Projections: Broadly there are two techniques to project revenue

✔ Top-down approach: under top-down approach, we first forecast industry, then market share of our company in that
projected industry.

✔ Bottom-up approach: under bottom-up approach, we build revenue projections based on likely demand of company’s
product and services from existing customers, growth in its customer base, price of product and services etc. Under this
approach we project company’s revenue driver, then on the basis which its revenue is projected.

Below we have discussed step-by-step explanation of both these approaches of projection.

Top-down approach

Step 1: Forecast industry size. We can build our own industry estimates or can refer professionals’ estimates. Usually we prefer taking
professional’s estimates unless its pretty niche industry not covered by professionals. in that situation we need to build our own
industry estimates as follows:

✔ Sizing target customer base using macro level data available for the target geographies

✔ Rate at which given product or service would be able to penetrate the potential market. if no precedent available then we can
look at past penetration trend of other products similar or close to our product.

The Economic Times Value & Valuations 95

 Revenue Projections
Step 2: Market share, our company would be able to grab of the total industry size estimated in step 1. Company’s market share would
depend upon its available capacity, future expansion plan, competition in the market, product differentiation etc.

Step 3: Estimate price of product/services, company is offering

Step 4: Projected Revenue = Industry size x Market share x Product price

Bottom-up approach

Step 1: Growth in demand from existing customer: Here we project how existing customer’s demand of company’s product will change. For
example; in case of a ecommerce company, we will project what would be change in average online spending per customer on
company’s website. For that we can refer to company’s historical trend of average revenue per customer, industry trend etc.

Step 2: Growth in number of customers: Expected addition of new customers net of churn rate of existing customers. While projecting growth
in customers, its important to refer how company has grown its customer base in past, what was its historical churn rate, technology
changes, emerging competition, penetration level in the industry

Step 3: Estimate price of product/services, company is offering

Step 4: Projected Revenue = Number of customer x Average Quantity per customer x Product price

The Economic Times Value & Valuations 96

 Key Points to discuss here

❑ Tax on EBIT, Why not on PBT (profit before tax)?

FCFF calculated above is discounted using cost of capital to the firm (i.e. WACC-Weighted average cost of debt and equity). In WACC
calculation, cost of debt is Interest rate x (1 – tax rate). As we have already captured tax shield on interest in WACC calculation,
considering the same in FCFF would result in double counting of tax shield on interest.

✔ To avoid double counting of tax shield on interest, would it be ok if we ignore tax shield on interest in WACC calculation and
consider the same in FCFF calculation?

Answer is no. While doing this, we might be correct mathematically but conceptually wrong at both FCFF and WACC
calculation as

o FCFF is cash flow available for distribution to whole capital invested in the business. Interest is debt claim on cash
flows which is not deducted while calculating FCFF hence tax shield on the same is ignored. FCFF is also called
unlevered free cash flows as leverage in the business has no impact on FCFF. Considering tax shield on the interest
would make your cash flow partly impacted by interest expenses.

o In WACC calculation considering gross cost of debt as Kd would be wrong as company is saving tax on the interest
cost and actual cost of debt is Kd net of tax

Add: Depreciation & Amortisation Exp.

❑ Reinvestment in the Business =
Less: Capital Expenditure
Add/Less: Change in Working Capital

The Economic Times Value & Valuations 97

 ❑ Capital expenditure we incur in the business includes two parts

▪ Maintenance capital expenditure, and

▪ 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.

The Economic Times Value & Valuations 98

Convergence Model
During phase II in three stage model (discussed above), the company’s growth declines due to increased competition and margins stabilise
to industry average. In initial growth phase, the company enjoys;
a) high growth and high margin due to competitive advantage which eventually wipes out as the business reaches the maturity
stage (ROIC = WACC),
or
a) high growth and negative margin due to higher marketing and customer acquisition cost which eventually reach to average
industry margin as the business and industry reaches the maturity stage and investor focus shifts from growth to profitability (e.g.
e-commerce industry)

Phase I Phase II Phase III

Growth (g)

FCFF

EBIT Margin
ROIC

WACC

The Economic Times Value & Valuations 99

WACC CALCULATION

The Economic Times Value & Valuations 100

 WACC Calculation

Risk Free Rate

6.75%
Beta
Equity / Total
x Cost of Equity + 1.1
Capital
75% 15.0%
x MRP

WACC 7.5%
Risk Premium
(Nominal)
+
12.9% 8.25%

Cost of debt

Debt / Total Cost of Debt 9.0%

x x
Capital (Net of Tax)
25% 6.75%

Tax Shield
(1-t)
25%
*Based on credit rating of the company

The Economic Times Value & Valuations 101

 Cost of Debt

Pre-Tax Cost of Debt

❑ The cost of debt should be assumed to be the current cost of issuing new long term debt for the company or project being analyzed

Source of Information:

❑ Cost of recent debt issued by the company

❑ Current bond yield on the company’s debt if its listed in the market

❑ Adding rating based default spread (both country default spread and company default spread), to risk free rate

✔ Alternatively we can add just company default spread to 10 year government bond rate as government bond rate already
includes country default spread

The Economic Times Value & Valuations 102

 Tax Rate

Marginal Tax Rate

❑ The prevailing statutory tax rate should be used in calculating the after-tax cost of debt

The Economic Times Value & Valuations 103

 Capital Structure

D
D+E

Capital Structure Weightings:

❑ Debt includes all interest bearing liabilities (short term debt, long term debt, capital lease etc.). It also includes

✔ Operating leases if capitalized = The debt value of operating leases is the present value of the future lease payments, where
discount rate would be the cost of debt for the company

❑ The debt component should be indicative of the market value of the debt

✔ In general, book value is a close proxy to market value else we can calculate market value of debt as discussed above

✔ For companies in cyclical industries, consider using average debt

❑ The equity component should be indicative of the public market value1 of the equity

1
If the company is not public, use comparables analysis

The Economic Times Value & Valuations 104

 Risk Free Rate

❑ Usually government bond rates are good measure of risk free rate of the country

❑ Which government security? Treasury bills, or 10/20/30 years govt. bond

Selection of security depends upon duration of project being analysed. If analysis is done for short term projects then short term
government securities should be used as risk free rate and for long term project it should be long term security return

✔ Therefore if we are doing analysis for very short duration investment, then treasury bills can also be taken as risk free rate

✔ In case of valuation of companies, we capture and discount cash flows for entire life of the company which usually goes upto infinity.
It means we should consider longest available security return as risk free rate. However, we have very frequent practice of
considering YTM on 10 years government as better proxy of risk free rate

o Compared to treasury bills because of better duration matching and less volatility (i.e. beta)

o Compared 20 years/ 30 years bonds because of less liquidity premium compared to longer term bonds

Note: If the government bond is not available in the country then GDP growth rate can be used as proxy of risk free rate as usually GDP
growth rate is close to risk free rate of the country

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 Risk Free Rate - Real vs Nominal

Real vs Nominal

❑ Using real or nominal risk free rate is dependent upon cash flows you are discounting. If cash flows are projected in nominal term, then
risk free rate should also be nominal and visa versa.

Real risk free rate = Nominal risk free rate – expected long term inflation

Or

Return on inflation indexed treasury

❑ In the situation of hyper and unstable inflation, we do projections in real terms (i.e. by ignoring growth coming due to inflation) and also
consider real discount rate to discount this real projected cash flows to present value.

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 Beta

❑ Beta is a measure of exposure to macro economic risk (systematic risk). It’s the risk of variance around the expectation of investors. The
companies are exposed to two types of risk; 1) Business Risk and 2) Leverage Risk.

✔ Business risk is the risk associated with the operation of the company (e.g. business risk of IBM is different from Walmart. IBM
caters Technology sector whereas Walmart caters to Retail sector)

✔ Leverage risk is the risk associated with having debt in the capital structure. More the debt in the capital structure of the company
higher would be risk of bankruptcy, resulting in higher beta

❑ Total beta of the company is also called levered beta as it includes both the risk, business as well as leverage risk

❑ Unlevered beta includes only business risk

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 There are two approaches to calculate beta

Approach 1: Regression Beta: Calculated based on historical price volatility, relative to the market

Where, re = %age change in stock price

rm = %age change in market index

✔ Period: 2-3 years data is sufficient to calculate regression beta. Too short period beta may be noisy due to small data size.
Too large period beta may not be relevant due to change in risk profile of the company.

✔ Weekly change is preferred over daily change

Step by Step approach

Step 1: Calculate regression beta of the company based on its historical price volatility relative to the market

Strep 2: Unlever the beta calculated under step 1 with the historical capital structure of the company (take out the average
historical leverage risk from levered beta)

Step 3: Relever the beta calculated under step 2 with the target capital structure of the company

Note: Step 2 and 3 are required in case the target leverage is different from historical leverage

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 Approach 2: Bottom Up Beta: Calculated based on beta of peer group companies

Step by Step approach

Step 1: Take levered beta of peer group companies (more the number of peers, better it would be)

Step 2: Calculate Unlevered Beta of the peers based on their respective capital structure

Step 3: Calculate the average unlevered beta of the industry

Step 4: Relever the beta calculated under step 3 with the target capital structure of the company being analyzed

❑ Bottom up beta is generally preferred over regression beta due to following reasons

✔ Law of large numbers: chances of error would be less in case of bottom up beta as its based on the data of larger number of firms
compared to just one firm data in case of regression beta

✔ If there are some exceptional movements in the stock price of the company in the past not explained by the market, in that case
regression beta tend to be low even for the high risky company

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 Unlevered and Relevered Beta

Calculation of Unlevered Beta

Note: Use the current capital structure in case of regression beta or industry average capital structure in case of bottom up beta

Calculation of Relevered Beta

Note: Use the target capital structure of the company being analyzed

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Few Fine Points on Beta
❑ Why different firm have different beta (some have high beta, some have low)? As discussed above beta of the firm is dependent upon
business risk and leverage risk

▪ Business risk of the company is dependent upon the nature of products or services it offers

✔ Other factors remaining same, more discretionary the product is, higher the beta would be. (e.g. beta of auto companies would be
high because of high discretionary product)

✔ Operating leverage means %age of fixed cost in total cost structure. Other factors remaining same, higher the operating
leverage, higher the beta would be due to its rigid cost structure. [With slight change in topline, there would be high volatility in the
earnings of these type of companies due to less flexibility in their cost structure]

▪ Leverage risk, other factors remaining same, higher the proportion of debt in the capital structure of the company, higher would be risk
of bankruptcy, resulting in higher beta

❑ As we all know that beta we calculates with respect to market captures only systematic risk (i.e. the risk associated with macro economic
scenario). It captures the volatility in companies’ stock price relative to the market as whole. In other words, it doesn’t captures unsystematic
risk (unsystematic risk is the company specific risk).

Now the question is if beta captures only systematic risk then how unsystematic risk is captured in the cost of equity and how the investor is
compensated for the same.

The answer is, as unsystematic risk can be mitigated by the investors by diversification, they should not be compensated for the same. If the
investor is not diversified then he/she is exposed to both systematic and unsystematic risk.

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 Equity Risk Premium

❑ Equity Risk Premium: Equity risk premium (“ERP”) represents the excess return demanded by investors over a risk-free rate

✔ This excess return compensates investors for taking on higher risk of the equity market

❑ Sources of ERP

✔ Historical returns of indices: Historical rates of returns of local indices above a country’s risk free rate can be used to estimate
Equity risk premium

✔ Survey based expected ERP: Where research agency try to gauge expected ERP by conducting surveys on the market
participants

✔ Predictive model: under predictive model of ERP, we try to estimate future return from market indices based on its current level,
future earning growth etc.

❑ ERP based on other matured market: In case we don’t have enough data or data is highly distorted to calculate ERP for the country,
we can calculate ERP for the country with reference to matured market ERP.

ERP of the Country* = Matured market ERP + Country risk premium

*Country where the company is situated

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 Cost of Equity

Cost of Equity Risk Free Rate Beta ERP

▪ Bottom up beta based on ▪ If Country specific data to

▪ Should be in Same currency
peers in the same industry is calculate ERP is available
as Cash Flows are
preferred over regression beta ✔ Based on historical excess
▪ 10 year government bond of the company return
rate
▪ Add company own leverage ✔ Based on survey
▪ Real or nominal depending risk in bottom up unlevered
upon cash flows beta ✔ Based on predictive models

▪ Based on Matured Market.

Matured market ERP + Country
risk Premium

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 Thank You

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