2. Basis for all valuation
approaches
• The use of valuation models in investment decisions (i.e., in decisions
on which assets are under valued and which are over valued) are
based upon
• a perception that markets are inefficient and make mistakes in assessing
value
• an assumption about how and when these inefficiencies will get corrected
• In an efficient market, the market price is the best estimate of value.
The purpose of any valuation model is then the justification of this
value
3. Methods of
Valuation
• DCF (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 it’s 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 cashflows 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, cashflows, book value or sales
• Contingent claim valuation, uses option pricing models to measure
the value of assets that share option characteristics
5. 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
• Philosophical Basis: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash flows, growth
and risk
• 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
• Market Inefficiency: 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
7. A few important
terms
• Cost of capital, from the perspective on an investor, is the minimum
return expected by whoever is providing the capital for a business
• Cost of Debt – Return expected by debt providers
• Cost of Equity - Return expected by equity shareholders
• Weighted Average Cost of Capital (WACC) - calculation of a firm's
cost of capital in which each category of capital is proportionately
weighted
• Beta – measure of the volatility, or systematic risk, of an asset in
comparison to the market as a whole
• Risk-free rates - theoretical rate of return of an investment with zero
risk
12. Estimating Inputs: Cost of
Debt
• The cost of debt is the rate at which you can borrow at currently. It
will reflect not only your default risk but also the level of interest
rates in the market
• The two most widely used approaches to estimating cost of debt
are:
• Looking up the Yield to Maturity (YTM) on a straight bond outstanding from
the firm. The limitation of this approach is that very few firms have long term
straight bonds that are liquid and widely traded
• Looking up the rating for the firm and estimating a default spread based upon
the rating. While this approach is more robust, different bonds from the same
firm can have different ratings. You have to use a median rating for the firm
13. Estimating Inputs:
Cashflows
Two pathways to the same goal
• Free Cash Flow to Firm (FCFF) – Free cash flow to the firm (FCFF)
represents the cash flow from operations available for distribution
after accounting for depreciation expenses, taxes, working capital,
and investments
• Free Cash Flow to Equity (FCFE) - Free cash flow to equity calculates
how much cash is available to the equity shareholders of a company
after all expenses, reinvestment, and debt are paid
15. Measuring
FCFEs
• Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures
Depreciation) - (Change in Non cash Working Capital) + (New Debt
Issued - Debt Repayments)
Or
• Free Cash Flow to Equity (FCFE) = FCFF + New Debt Issued - Debt
Repayments – Interest on Debt
20. Estimating Terminal
Value
So, using FCFFs, Terminal Value is
TV =
FCFFn+1
WACC - g
Where, g = Return on Capital (RoC) * (1 – FCFF /
Using FCFEs, Terminal Value is
TV = FCFEn+1
Cost of Equity - g
Where, g = Return on Equity (RoE) * (1 – FCFE /
Net income)
25. Important learnings: Value
enhancements
• The overall value of the company can be enhanced through:
• Increase in Cash flows from the assets in place
• Increase in expected growth
• Increasing length of the growth period
• Reducing cost of capital
31. Relative
Valuation
• What is it: The value of any asset can be estimated by looking at how the
market prices “similar” or ‘comparable” assets.
• Philosophical Basis: The value of an asset is whatever the market is willing
to pay for it (based upon its characteristics)
• Information Needed: To do a relative valuation, you need
• an identical asset, or a group of comparable or similar assets
• a standardized measure of value (also called multiples)
• and if the assets are not perfectly comparable, variables to control for the
differences
• Market Inefficiency: Pricing errors made across similar or comparable
assets are easier to spot, easier to exploit and are much more quickly
corrected.
35. Using multiples for valuation:
Example
• ABC Ltd. has earnings-per-share (EPS) of $12.
• DEG Ltd., a company comparable to ABC with similar business and
risk profile has an EPS of $10 and price per share of $150
• Find the value ABC Ltd.
• PE multiple of DEG = Price per share/EPS = 150 / 10 => 15x
• Using PE of 15x, Value of ABC is
• Value of ABC = PE * EPS => 15 * 12 => $180 per share
