1

VALUATION: FIRST STEPS

Cynic: A person who knows the price of everything but
the value of nothing..

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

First Principles
3

Maximize the value of the business (firm)

The Investment Decision

Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate

The hurdle rate

should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.

The return
should reflect the
magnitude and
the timing of the
cashflows as welll
as all side effects.

The Financing Decision

Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations

The optimal
mix of debt
and equity
maximizes firm
value

The right kind

of debt
matches the
tenor of your
assets

The Dividend Decision

If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business

How much
cash you can
return
depends upon
current &
potential
investment
opportunities

How you choose

to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks

Three approaches to valuaFon

4

Intrinsic valuaFon: The value of an asset is a funcFon of

its fundamentals cash ows, growth and risk. In
general, discounted cash ow models are used to
esFmate intrinsic value.
RelaFve valuaFon: The value of an asset is esFmated
based upon what investors are paying for similar assets.
In general, this takes the form of value or price mulFples
and comparing rms within the same business.
ConFngent claim valuaFon: When the cash ows on an
asset are conFngent on an external event, the value can
be esFmated using opFon pricing models.
4

One tool for esFmaFng intrinsic value: Discounted

Cash Flow ValuaFon
5

Value of growth
The future cash flows will reflect expectations of how quickly earnings will grow in the future (as a positive) and how much
the company will have to reinvest to generate that growth (as a negative). The net effect will determine the value of growth.
Expected Cash Flow in year t = E(CF) = Expected Earnings in year t - Reinvestment needed for growth
Cash flows from existing assets
The base earnings will reflect the
earnings power of the existing
assets of the firm, net of taxes and
any reinvestment needed to sustain
the base earnings.

Steady state
The value of growth comes from
the capacity to generate excess
returns. The length of your growth
period comes from the strength &
sustainability of your competitive
advantages.

Risk in the Cash flows

The risk in the investment is captured in the discount rate as a beta in the cost of equity and the default spread in the cost
of debt.

Equity ValuaFon
6

The value of equity is obtained by discounFng expected cashows

to equity, i.e., the residual cashows aQer meeFng all expenses,
tax obligaFons and interest and principal payments, at the cost of
equity, i.e., the rate of return required by equity investors in the
rm.
t=n

CF to Equity t
(1+k e )t
t=1

Value of Equity=

where,
CF to Equity t = Expected Cashow to Equity in period t
ke = Cost of Equity

The dividend discount model is a specialized case of equity

valuaFon, and the value of a stock is the present value of expected
future dividends.
6

Firm ValuaFon
7

The value of the rm is obtained by discounFng expected

cashows to the rm, i.e., the residual cashows aQer
meeFng all operaFng expenses and taxes, but prior to debt
payments, at the weighted average cost of capital, which is
the cost of the dierent components of nancing used by the
rm, weighted by their market value proporFons.
t=n

CF to Firm t
t
t=1 (1+WACC)

Value of Firm=

where,
CF to Firm t = Expected Cashow to Firm in period t
WACC = Weighted Average Cost of Capital
7

Choosing a Cash Flow to Discount

8

When you cannot esFmate the free cash ows to equity or

the rm, the only cash ow that you can discount is
dividends. For nancial service rms, it is dicult to esFmate
free cash ows. For Deutsche Bank, we will be discounFng
dividends.
If a rms debt raFo is not expected to change over Fme, the
free cash ows to equity can be discounted to yield the value
of equity. For Tata Motors, we will discount free cash ows to
equity.
If a rms debt raFo might change over Fme, free cash ows
to equity become cumbersome to esFmate. Here, we would
discount free cash ows to the rm. For Vale and Disney, we
will discount the free cash ow to the rm.

The Ingredients that determine value.

9

NarraFves and Numbers

10

Favored Tools
- Accounting statements
- Excel spreadsheets
- Statistical Measures
- Pricing Data

Favored Tools
- Anecdotes
- Experience (own or others)
- Behavioral evidence

A Good Valuation
The Numbers People

Illusions/Delusions
1. Precision: Data is precise
2. Objectivity: Data has no bias
3. Control: Data can control reality

The Narrative People

Illusions/Delusions
1. Creativity cannot be quantified
2. If the story is good, the investment will be.
3. Experience is the best teacher

10

Task
Make a judgment
on whether you
want to value
just the equity or
the operaFng
assets of your
company.

11

Read
Chapter 12