Valuation Presentation at Flame Institute June 2014 PDF

Lecture at Flame Institute on Valuation by
Samit Vartak, CFA

Co-Founder & CIO
June 11-15, 2014
Investment Advisors LLP
SageOne: Quest for Outstanding Investments

Valuation
• Tragedy: The value gets set first and Valuation exercise happens to fit the
number
• Is value real or in the eyes of the beholder?
– Only reality is that there is no fixed valuation of an asset?
– M&A, Diversified Portfolio Manager, Concentrated Investor, Foreign buyer.
• Is value driven by expected future cash flow? Or on hopes of bigger fool to
pay higher price?
• Is valuation an art or a science?
• Is there bias in valuation?
– All valuations are biased. The only questions are how much and in which
direction. E.g. TCS
– The direction and magnitude of the bias in your valuation is directly proportional
to who pays you and how much you are paid.
• Does complexity mean precision
– Understanding of a valuation model is inversely proportional to the number of
inputs required for the model.
– Simpler valuation models do much better than complex ones.
SageOne: Quest for Outstanding Investments 2
Investors need to know the range
• Its almost impossible to find a fixed valuation
ROCE
Under
> Valuation
Exp Return Valuation Range Over Valuation
• Its not impossible to tell whether current price is a bargain

Purposes of Valuation
• In company buying and selling operations:
– For the buyer, the valuation will tell him the highest price he should pay
– For the seller, the valuation will tell him the lowest price at which he should be
prepared to sell.
• Strategic decisions on the company’s continued existence:
– The valuation of a company or business unit is a prior step in the decision to
continue in the business, sell, merge, milk, grow or buy other companies. E.g. HT
• Strategic planning:
– The valuation of the company and the different business units is fundamental for
deciding what products/business lines/countries/customers … to maintain grow
or abandon.
– The valuation provides a means for measuring the impact of the company’s
possible policies and strategies on value creation and destruction.

Purposes of Valuation
• Valuations of listed companies:
– The valuation is used to compare the value obtained with the share’s price on the
stock market and to decide whether to sell, buy or hold the shares
– The valuation of several companies is used to decide the securities that the
portfolio should concentrate on: those that seem to be undervalued by the
market
– The valuation of several companies is also used to make comparisons between
companies. For example, if an investor thinks that the future course of HDFC
Bank’s share price will be better than that of ICICI Bank, he may buy HDFC
Bank’s shares and short-sell ICICI Bank’s shares.
• Public or private offerings:
– The valuation is used to justify the price at which the shares are offered to the
public or PE/VC funds

Approaches to Valuation
• Book value
– Value of the shareholders’ equity stated in the balance sheet (capital and
reserves).
– This quantity is also the difference between total assets and liabilities, that is, the
surplus of the company’s total goods and rights over its total debts with third
parties.
Assets Liabilities
Cash 5 Accounts Payables 40

Accounts Receivable 10 Short-term Debt 10
Inventories 45 Long-term Debt 30
Fixed Assets 100 Shareholder's Equity 80
Total Assets 160 Total Liabilities 160

• Adjusted Book Value
– When the values of assets and liabilities match their market value, the adjusted
net worth is obtained.
Assets Liabilities
Cash 5 Accounts Payables 40

Accounts Receivable 8 Short-term Debt 10
Inventories 52 Long-term Debt 30
Fixed Assets 150 Shareholder's Equity 135
Total Assets 215 Total Liabilities 215

• Liquidation Value
– Minimum Value if it is liquidated, that is, its assets are sold and its debts are paid
off. This value is calculated by deducting the business’s liquidation expenses
(redundancy payments to employees, tax expenses and other typical liquidation
expenses) from the adjusted net worth.
– If liquidation expenses are 35, Liquidation value = 135 – 35 = 100 in the above
case
• Replacement Value
– Represents the investment that must be made to form a company having
identical conditions as those of the company being valued
– Should be adjusted for cash flow loss during period of formation
• Options Pricing
– Used for All or None kind of returns. E.g. Oil drilling, drug discovery

Typical Approaches to Valuation for Investors
• Discounted cash flow valuation, relates the value of an asset to the
present value of expected future cash flow on that asset.
• Relative Valuation (very briefly), 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.
What valuation method do you use for your personal investments?

Simple fundamentals of valuation
• How much do I want to pay NOW for expected future cash flow?
– Your expected returns drive how much you want to pay NOW
– E.g. 5 year g-sec: FV = 100, Coupon = 10%
Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
Coupon (interest paid) 10% 10.00 10.00 10.00 10.00 10.00

Principal Paidback 100.00
Reinvest 0% - - - - -
Payout 10.00 10.00 10.00 10.00 110.00
Expected Return 10% 0.91 0.83 0.75 0.68 0.62

9.09 8.26 7.51 6.83 68.30
Present Value 100.00
CF1 CF2 CF3 CF4 CFn

Value = 1
+ 2
+ 3
+ 4
..... +
(1 + r) (1 + r) (1 + r) (1 + r) (1 + r) n
• How much do I want to pay NOW for expected future cash flow?
– Your expected returns drive how much you want to pay NOW
– E.g. 5 year g-sec: FV = 100, Coupon = 0%
Years 1 2 3 4 5
Capital 100.00 110.00 121.00 133.10 146.41
Interest (coupon unpaid) 10% 10.00 11.00 12.10 13.31 14.64

Principal + Interest Paidback 146.41
Reinvest 100% 10.00 11.00 12.10 13.31 -
Payout - - - - 161.05
Expected Return 10% 0.91 0.83 0.75 0.68 0.62

- - - - 100.00

• Value changes with change in expected yield/return or coupon
Years 1 2 3 4 5
Coupon 10% 10.00 10.00 10.00 10.00 110.00
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
8.70 7.56 6.58 5.72 54.69
Present Value 83.24
Years 1 2 3 4 5
Coupon 10% 10.00 10.00 10.00 10.00 110.00
Expected Return 8% 0.93 0.86 0.79 0.74 0.68
9.26 8.57 7.94 7.35 74.86
• You can always get your expected returns by paying a price over or under
its face value

• Let’s replace g-sec example with a business
– Business returns 10% on its capital
– No leverage; Hence ROCE = ROE
Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
PAT 10% 10.00 10.00 10.00 10.00 10.00

Return on Capital (ROE) 10% 10% 10% 10% 10%
Reinvest
Payout
0% -
10.00
-
10.00
-
10.00
-
10.00
-
10.00
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
8.70 7.56 6.58 5.72 4.97
Present Value 67

• When expectations and return match, value doesn’t change with duration
Years 1 2 3 4 5
Capital 100.00 107.50 115.56 124.23 133.55
PAT 15% 15.00 16.13 17.33 18.63 20.03

Reinvest
Payout
50% 7.50
7.50
8.06
8.06
8.67
8.67
9.32
9.32
10.02
10.02
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
6.52 6.10 5.70 5.33 4.98
Present Value 100

Money invested at returns > expected return
generates value (i.e. MV > BV)
Money invested at returns < expected returns

destroys value (i.e. MV < BV)

Does earnings growth create value?

Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
PAT 10% 10.00 10.00 10.00 10.00 10.00

Reinvest
Payout
0% -
10.00
-
10.00
-
10.00
-
10.00
-
10.00
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
8.70 7.56 6.58 5.72 4.97
Present Value 67
- PAT CAGR = 0
- fwd PE x = 67/10 = 6.7
- ttm P/B x = 67/100 = 0.67

Years 1 2 3 4 5
Capital 100.00 105.00 110.25 115.76 121.55
PAT 10% 10.00 10.50 11.03 11.58 12.16

Reinvest
Payout
50% 5.00
5.00
5.25
5.25
5.51
5.51
5.79
5.79
6.08
6.08
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
4.35 3.97 3.62 3.31 3.02
Present Value 50
- PAT CAGR = 5%
- fwd PE x = 50/10 = 5
- ttm P/B x = 50/100 = 0.5
-e.g. Bajaj Electricals. Can consumer business value > combined business?
Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
PAT 15% 15.00 15.00 15.00 15.00 15.00

Reinvest
Payout
0% -
15.00
-
15.00
-
15.00
-
15.00
-
15.00
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
13.04 11.34 9.86 8.58 7.46
Present Value 100
- PAT CAGR = 0%
- fwd PE x = 100/15 = 6.7
- ttm P/B x = 100/100 = 1

Years 1 2 3 4 5
Capital 100.00 107.50 115.56 124.23 133.55
PAT 15% 15.00 16.13 17.33 18.63 20.03

Reinvest
Payout
50% 7.50
7.50
8.06
8.06
8.67
8.67
9.32
9.32
10.02
10.02
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
6.52 6.10 5.70 5.33 4.98
Present Value 100
- PAT CAGR = 7.5%

- fwd PE x = 100/15 = 6.7
- ttm P/B x = 100/100 = 1

Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
PAT 20% 20.00 20.00 20.00 20.00 20.00

Reinvest
Payout
0% -
20.00
-
20.00
-
20.00
-
20.00
-
20.00
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
17.39 15.12 13.15 11.44 9.94
Present Value 133
- PAT CAGR = 0%
- fwd PE x = 133/20 = 6.7
- ttm P/B x = 133/100 = 1.33

Years 1 2 3 4 5
Capital 100.00 110.00 121.00 133.10 146.41
PAT 20% 20.00 22.00 24.20 26.62 29.28

Reinvest
Payout
50% 10.00
10.00
11.00
11.00
12.10
12.10
13.31
13.31
14.64
14.64
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
8.70 8.32 7.96 7.61 7.28
Present Value 200
- PAT CAGR = 10%

- fwd PE x = 200/20 = 10
- ttm P/B x = 200/100 = 2

Years 1 2 3 4 5
Capital 100.00 120.00 144.00 172.80 207.36
PAT 20% 20.00 24.00 28.80 34.56 41.47

Reinvest
Payout
100% 20.00
-
24.00
-
28.80
-
34.56
-
41.47
-
∞
Expected Return 15% 0.87 0.76 0.66 0.57 0.50
- - - - -
Present Value Infinity
- PAT CAGR = 20%

- fwd PE x = Infinity
- ttm P/B x = Infinity
• This is impossible in reality as the value would surpass that of our
entire world

Growth can be increased by increasing
investments
Growth will increase value ONLY IF the returns

earned on the new investments exceed
expected return

• Demonstration of what happens to value over time
Years 1 2 3 4 5
Starting Capital 100.00 110.00 121.00 139.15 160.02
ROCE 10% 10% 15% 15% 10%

Incremental Cash Flow 10.00 11.00 18.15 20.87 16.00
Ending Capital 110.00 121.00 139.15 160.02 176.02

Expected Return 10% 0.91 0.83 0.75 0.68 0.62
Present Value 100.00 100.00 104.55 109.30 109.30
• Valuation of all businesses peak at some finite time. That’s when you
calculate the “Terminal Value”

• Graph of Present Value over Time
125
ROCE > Exp Return ROCE = Exp Return ROCE < Exp Return
120
115
110
105
100
95
1 2 3 4 5 6 7 8 9 10
• Valuation of all businesses peak at some finite time

Factors for Expected Return (“r”)
Predictability and Consistency of • How predictable
earnings • Probability of loss
• Probability of negative growth
Size (Mcap/Sales) of the company • Regional or national

• Promoter driven or professional
Liquidity of the shares • Impact cost for funds
• Illiquidity discount or scarcity
premium (e.g. Gruh, Page)
Who are the investors • What's their opportunity cost
Investment horizon • Are the investors investing for a

short term profit making trade or
long term

Expected growth and return pattern
Year 1 Year 2 Year 3 Year 4 Year 5 CAGR
Nifty 25% 25% 25% 25% -25% 12.9%
Company 1 40% 40% 40% 40% -60% 9.0%
Company 2 25% 25% 25% 25% -20% 14.3%

Factors for Sustainable Growth (“g”)
Inherent growth of the industry • How does it relate to GDP growth of the
country or some other driver
Entry Barriers • Licenses, Brand, Land, Resources,
Technology, Patent, Process, etc.
Size of unorganized market • Can organized players capture the

unorganized market share and grow
faster than the industry
Untapped potential • Are there new customers adapting to

the products or services
• Are there applications in new segments
Market share gain • Is the company taking market share

from competitors
• Are there inefficient PSUs?
Consumable/Capex driven • Is the company product a consumable
or capex driven

Sustainable PE multiple
Sustainable PE x of a stock
= payout ratio / (r - g)
where,
r = market expected return at stable growth
g = market expected constant growth rate
Let’s do examples for the following companies:
1. HDFC Bank
2. Magalam Cement

Ban on Gold Lease – Implications on Titan
• What would happen to its Capital Requirement
• Impact on ROCE
• Impact on Growth
• Impact on Expected Returns
• Overall impact on Multiples

Is reinvestment creating value?
FY12 FY11 FY10 FY9 FY8
Bajaj Electricals Ltd.
ROCE (EBIT/Cap Emp) 13.5% 17.5% 20.8% 20.5% 20.3%
Incr ROCE (Incr EBIT/Incr CE) -10.5% 5.7% 18.6% 17.7% 41.3%
5 Yr Incr ROCE 12%

Return on Capital
Operating Incomet (1 - tax rate)
Return on Capital (ROCE) =
Book Value of Invested Capitalt -1
• Capital Employed = Fixed Assets + Current Assets – Current Liabilities – Cash =
Fixed Assets + Non-cash Working Capital
• Tax adjustment to operating income, computed as a hypothetical tax based on an
effective or marginal tax rate
• Use of book values for invested capital, rather than market values
• Timing difference; the capital invested is from the end of the prior year whereas the
operating income is the current year’s number.
E.g. Assume that a firm has 100 crs in earnings before interest and taxes, 60 crs in interest
expenses and faces a tax rate of 33%. The taxable income for the firm is 40 crs (EBIT –
Interest Expenses) and the taxes paid will be 13.2 crs. The after-tax operating income that
should be used for the return on capital should be 67 crs (100 crs (1-.33)) and not 86.8 crs
(100 crs – 13.2 crs).
Return on Equity
Net Incomet - Interest Inc from Casht (1- tax)
Non-Cash Return on Equity (ROE) =
Book Value of Equityt -1− Casht -1
• If you are computing a return on equity to compare to the cost of equity for a
firm, where the cost of equity reflects all assets owned by the firm, the
conventional measure of ROE will suffice
• If the cost of equity is computed based on the riskiness of only the operating
assets of the firm, the non-cash ROE is the better measure of returns.

Creating Growth vs. Creating Value
• Growth in Net Operating Income = ROCE x Reinvestment Rate
– Reinvestment Rate = (Capex – Depr + WC)/EBIT (1-t)
– Value created if ROCE > Cost of Capital (WACC)
• Growth in net Income = ROE x Equity Reinvestment Rate

– Eq. Reinvestment rate = (Capex – Depr + WC - Debt)/Net Income
– Value created if ROE > Cost of Equity

Discounted Cash Flow Model

Bottomline: Simple fundamentals of valuation
• Value of perpetual (to infinity) growth above expected return results in
INFINITE value
• Any company who is capable of doing that will itself become the entire
economy and hence impossible
• Question is how long does the higher returning growth sustain
• After this, the return (from the business) falls below or at expected returns
level
• That’s the time to end forecast and calculate “Terminal Value”

Discounted Cash Flow (DCF)
• 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
CF1 CF2 CF3 CF4 CFn

Value of asset = + + + .....+
(1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) n
– where CFt is the expected cash flow in period t, r is the discount rate appropriate
given the riskiness of the cash flow and n is the life of the asset.

Discounted Cash Flow Model

DCF and Our Bond Examples
• Interest Paid: EBIT (1-t)
• Reinvestment: (Capex – Depr) + WC
• Payout: FCFF (Free Cash Flow to Firm) = EBIT (1-t) - Reinvestment
• Expected Return: WACC: Weighted Avg Cost of Capital (Debt, Equity, etc..)
• Principal Paidback: Terminal Value
• Present Value: Enterprise Value (EV): Value of Debt, Common Equity and
other stakeholder ownership
Years 1 2 3 4 5
Capital 100.00 100.00 100.00 100.00 100.00
Coupon (interest paid) 10% 10.00 10.00 10.00 10.00 10.00

Principal Paidback 100.00
Reinvestment 0% - - - - -
Payout 10.00 10.00 10.00 10.00 110.00
Expected Return 10% 0.91 0.83 0.75 0.68 0.62

9.09 8.26 7.51 6.83 68.30
Basic steps to valuation
• Figure out period (forecast period) of sustainable superior growth
• Estimate broadly what size the business would be able to achieve by the
end of such period and accordingly the growth rate
• Estimate the ROCE during such period
• Evaluate investment needed (reinvestment) based on ROCE and growth

rate per year
• Calculate terminal value at the end of the forecast period by assuming

perpetual sustainable growth rate (close to country growth rate) and
assuming ROCE close to Expected Return (WACC)

Enterprise Value
(less) Market value of Debt
(plus) Market value of Cash
(less) Market Value of Options/Warrants
(less) Market Value of Other Instruments
Market Value of Equity

Terminal Value

Fundamentals of Terminal Value
Terminal Value
Liquidation Multiple Approach Stable Growth

Value Model
Most useful Easiest approach but Technically soundest,

when assets makes the valuation but requires that you
are separable a relative valuation make judgments about
and when the firm will grow
marketable at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.

Fundamentals of Terminal Value
• When a firm’s cash flows grow at a “constant” rate forever. This “constant” growth
rate is called a stable growth rate and cannot be higher than the growth rate of the
economy in which the firm operates. The present value of those cash flows can be
written as:
Value = CF(t+1) / (r - g) = t = ∞ CF
∑ t
where, t
t = 1 (1 + r)
r = Expected return at stable growth
g = Expected constant growth rate
Gordon Model
• E.g. Value below = 5/(15% - 5%) = 50
Years 1 2 3 4 5
Capital 100.00 105.00 110.25 115.76 121.55
PAT 10% 10.00 10.50 11.03 11.58 12.16

Reinvest 50% 5.00 5.25 5.51 5.79 6.08

Payout
Expected Return 15%

5.00
0.87
5.25
0.76
5.51
0.66
5.79
0.57
6.08
0.50
∞
4.35 3.97 3.62 3.31 3.02
Present Value 50
Terminal Value and Growth
ROCE 15%
Expected Return ® 15%

FCF (t+1) -
Growth Reinvestment Reinvestme
Rate (g) Needed = g/ROCE nt TV = FCF (t+1)/(r-g)
0% 0% 100 667
2% 13% 87 667
4% 27% 73 667
6% 40% 60 667
As growth increases, value does not change. Why?

Under what conditions will value increase as growth increases?
Under what conditions will value decrease as growth increases?

Comments on Terminal Value
• Strange though this may seem, the terminal value is not as much a function
of stable growth as it is a function of what you assume about excess returns
in stable growth.
• In the scenario where you assume that a firm earns a return on capital
equal to its cost of capital in stable growth, the terminal value will not
change as the growth rate changes.
• If you assume that your firm will earn positive (negative) excess returns in
perpetuity, the terminal value will increase (decrease) as the stable growth
rate increases.

Exit value may defy fundamentals (intrinsic value)
• What if my final payment (terminal value) is not guaranteed
• Valuing a flat in Mumbai?

– Property value = 100 L; Rental income = 3% ; Exit value = ??
Years 1 2 3 4 5
Coupon 3% 3.00 3.00 3.00 3.00 3.00
Exit Value 142.74
Expected Return 10% 0.91 0.83 0.75 0.68 0.62
2.73 2.48 2.25 2.05 90.49
Fundamental?
• Using the TV formula: Assume g = 5% (long-term rental growth rate)

– Exit Value = 3*1.05/(10%-5%) = 63 L (Fundamental value way below paid)

Estimating “r” and “g” in the
Terminal Value Model

How high can the stable growth rate be?
• The stable growth rate cannot exceed the growth rate of the economy but it
can be set lower.
– If you assume that the economy is composed of high growth and stable growth
firms, the growth rate of the latter will probably be lower than the growth rate of
the economy.
– The stable growth rate can be negative. The terminal value will be lower and you
are assuming that your firm will disappear over time.
– If you use nominal cashflows and discount rates, the growth rate should be
nominal in the currency in which the valuation is denominated.
• One simple proxy for the nominal growth rate of the economy is the riskfree
rate.
– Riskfree rate = Expected inflation + Expected Real Interest Rate
– Nominal growth rate in economy = Expected Inflation + Expected Real Growth

What else should change in stable growth?
• In stable growth, firms should have the characteristics of other stable growth
firms. In particular,
– The risk of the firm, as measured by beta and ratings, should reflect that of a
stable growth firm.
• Beta should move towards one
• The cost of debt should reflect the safety of stable firms (BBB or higher)
– The return on capital generated on investments should move to sustainable

levels, relative to both the sector and the company’s own cost of capital.

Terminal Value and long-term PE multiple
Long term PE x of a stock
PEx at terminal period = payout ratio / (r - g)

where,
r = market expected return at stable growth
g = market expected constant growth rate
Let’s do examples for the following companies:
1. HDFC Bank
2. Coromandel Intl

Estimating Cost of Equity

DCF - Cost of Equity

Benchmark for Cost of Equity
Nominal GDP Growth at 13.2% and Sensex EPS Growth at 14.9%

(1993 - 2012)
1200 80000
70000
1000
60000
800
50000
600 40000
30000
400
20000
200
10000
0 0
GDP Rs. Bn (Current Prices) Sensex EPS Year

Risk Free Rate
For a rate to be riskfree in valuation, it has to be long term, default free

and currency matched (to the cash flows)

More on Risk Free Rate
• In May 2012, the 10-year treasury bond rate in the United States was 1.5%,
a historic low. You are valuing a company in US dollars but are wary about
the riskfree rate being too low. Which of the following should you do?
a) Replace the current 10-year bond rate with a more reasonable normalized
riskfree rate (the average 10-year bond rate over the last 5 years has been about
3.5%)
b) Use the current 10-year bond rate as your riskfree rate but make sure that your
other assumptions (about growth and inflation) are consistent with the riskfree
rate
c) Something else…

Equity Risk Premium and Issues with it
• The historical premium is the premium that stocks have historically earned
over riskless securities.
• Practitioners never seem to agree on the premium; it is sensitive to
– How far back you go in history…
– Whether you use T.bill rates or T.Bond rates
– Whether you use geometric or arithmetic averages.
• For instance, looking at the US:
Bonds have outperformed equities over the last 2 decades in India as well
as US. So now do you use negative risk premium?
Which equity risk premium should you use?
• Historical Risk Premium: When you use the historical risk premium, you are
assuming that premiums will revert back to a historical norm and that the
time period that you are using is the right norm.
• Current Implied Equity Risk premium: You are assuming that the market is
correct in the aggregate. If you are required to be market neutral, this is the
premium you should use. (What types of valuations require market
neutrality?)

Implied Equity Risk Premium

Implied Equity Risk Premium

Historical Implied Risk Premium
Sensex
CY Avg of BSE Mcap BSE GDP INR bn Nominal BSE
Earnings High & Sensex Sensex Sensex INR bn (FY Mcap (Current GDP Mcap/GD Interest Impplied
Earnings Growth Low Fwd P/E Bwd P/E CY P/B end) Growth Prices) Growth P Rates ERP
FY 1993 81 2,720 21.08 33.57 4.8 3,136 7,526 0.42 13.0 4.7%
FY 1994 129 59% 4,025 22.24 31.20 6.1 3,681 17% 8,658 15% 0.43 13.5 4.5%
FY 1995 181 40% 3,418 13.67 18.88 3.8 4,355 18% 10,158 17% 0.43 12.5 7.3%
FY 1996 250 38% 3,422 12.87 13.69 3.0 5,265 21% 11,918 17% 0.44 14.0 7.8%
FY 1997 266 6% 3,851 13.23 14.48 2.8 4,639 -12% 13,786 16% 0.34 13.8 7.6%
FY 1998 291 9% 3,532 12.70 12.14 2.3 5,603 21% 15,272 11% 0.37 12.8 7.9%
FY 1999 278 -4% 4,097 14.63 14.74 3.1 5,454 -3% 17,512 15% 0.31 12.4 6.8%
FY 2000 280 1% 4,821 22.32 17.22 3.8 9,128 67% 19,520 11% 0.47 11.9 4.5%
FY 2001 216 -23% 3,528 14.95 16.34 2.5 5,716 -37% 21,023 8% 0.27 11.0 6.7%
FY 2002 236 9% 3,293 12.11 13.95 2.3 6,122 7% 22,790 8% 0.27 9.2 8.3%
FY 2003 272 15% 4,413 12.68 16.22 2.5 5,722 -7% 24,546 8% 0.23 7.5 7.9%
FY 2004 348 28% 5,422 12.05 15.58 3.3 12,012 110% 27,546 12% 0.44 6.1 8.3%
FY 2005 450 29% 7,756 14.83 17.24 3.9 16,984 41% 31,494 14% 0.54 6.5 6.7%
FY 2006 523 16% 11,417 15.90 21.83 4.8 30,222 78% 35,867 14% 0.84 7.6 6.3%
FY 2007 718 37% 16,407 19.70 22.85 5.3 35,450 17% 41,292 15% 0.86 8.1 5.1%
FY 2008 833 16% 14,452 17.62 17.35 4.2 51,380 45% 47,234 14% 1.09 8.3 5.7%
FY 2009 820 -2% 12,789 13.55 15.60 3.4 30,861 -40% 53,218 13% 0.58 7.0 7.4%
FY 2010 944 15% 19,190 18.72 20.33 3.7 66,608 116% 61,200 15% 1.09 8.0 5.3%
FY 2011 1025 9% 17,500 15.52 17.07 3.5 65,590 -2% 70,380 15% 0.93 8.3 6.4%
FY 2012 1128 10% 17,200 14.33 15.25 3.4 64,465 -2% 79,530 13% 0.81 8.5 7.0%
Median 15.1% 14.73 16.70 3.48 17.4% 14.3% 0.44 8.9 6.8%
CAGR 14.9% 10.2% 17.2% 13.2%
* Dividend yield not includedSageOne:

in Sensex return
Quest for Outstanding Investments 62
When would equity risk premium be highest?
– Bull market
– Bear market
– Normal times
– Crisis/panic situation

Beta – Risk Evaluation

Beta: Example of Risk Averse Investors
• Constant stream vs. coin flip related cash flow
• Now what happens if time horizon increases
• Cyclical companies and coin flip
• Traders vs. long-term investors
• Dividend vs. Buyback

Beta and Issues with it
• Beta measures relative risk of a security with the market
• If you are not evaluating an equity to buy as part of a well diversified

portfolio, Beta would under estimate risk
• Beta changes depending on the time frame and at various stages of a

business cycle
• Doesn’t incorporate risk reduction due to margin of safety due to price

– E.g. deep fall in valuation typically increases beta, but in reality may have
reduced further downside risk
• Doesn’t incorporate risk due to aggressiveness of forecast

Beta – What Beta will you use
Beta June '12

Fin
Crisis
Jun 08- Low High 5 yr Sales 5 yr EPS 5 yr ROE
1 yr 5 yr 09 RFR ERP COE COE Diff Gwth Range Gwth Range Range
IDFC 1.56 1.41 1.44 8.3% 7% 18.2% 19.2% 1.1%11% - 78% 1% - 41% 13% - 18%
ICICI Bank 1.51 1.45 1.61 8.3% 7% 18.5% 19.6% 1.1%-1% - 30% -4% - 32% 7% - 14%
HDFC Bank 0.94 0.95 0.99 8.3% 7% 14.9% 15.2% 0.4%30% - 40% 17% - 31% 17% - 20%
ITC 0.51 0.59 0.52 8.3% 7% 11.9% 12.4% 0.6%13% - 23% 5% - 24% 26% - 33%
Infosys 0.95 0.71 0.69 8.3% 7% 13.1% 15.0% 1.8%5% - 30% 4% - 29% 28% - 37%
NTPC 0.77 0.84 0.74 8.3% 7% 13.5% 14.2% 0.7%10% -23% 5% - 18% 14% - 15%
Shriram Trans Fin 0.88 0.46 0.27 8.3% 7% 10.2% 14.5% 4.3%19% - 76% 13% - 86% 20% - 30%
Titan Ind. 0.91 0.81 0.67 8.3% 7% 13.0% 14.7% 1.7%22% - 45% 11% - 72% 32% - 50%
BHEL 1.21 1.02 1.02 8.3% 7% 15.4% 16.8% 1.3%12% - 36% 10% - 44% 26% - 33%
Hawkins 0.59 0.53 0.48 8.3% 7% 11.7% 12.4% 0.8%16% - 27% -14% - 93% 50% - 112%
TTK Prestige 0.90 0.53 0.32 8.3% 7% 10.5% 14.6% 4.1%16% - 50% 8% - 135% 30% - 54%

Beta of small cap index

Beta: How to evaluate risk
"It is better to be roughly right than precisely wrong."

Is Beta an Adequate Measure of Risk for a Private
Firm?
The owners of most private firms are not diversified. Beta measures the risk
added on to a diversified portfolio. Therefore, using beta to arrive at a cost
of equity for a private firm will
a) Under estimate the cost of equity for the private firm
b) Over estimate the cost of equity for the private firm
c) Could under or over estimate the cost of equity for the private firm

Total Risk versus Market Risk
• Adjust the beta to reflect total risk rather than market risk. This adjustment is
a relatively simple one, since the R squared of the regression measures the
proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
• To estimate the beta for ABC, we begin with the bottom-up unlevered beta
for the comparables in the industry:
– Unlevered beta for publicly traded companies in a industry = 0.7
– Average correlation co-eff of food processing companies with market = 0.6
– Unlevered total beta for ABC = 0.7/0.6 = 1.17
– Debt to equity ratio for ABC = 0.3/0.7 (assumed industry average)
– Total Beta = 1.17 ( 1 + (1-.34)(30/70)) = 1.5
– Total Cost of Equity = 8.2%Quest

SageOne: + 1.5for(7%) = 18.7%
Outstanding Investments 71
Rechecking if estimated Beta makes sense
Type of Risk Factors
Business Risk Reliability of inputs, drivers,

competition, regulatory risk,
discretionary products, Black Swan
Firm-specific Risk Execution, corporate governance,
leverage (FX risk), promoter
dependence, implied growth
Macro Risk Interest rates, GDP growth, Global
shocks, currency risk
Which business would you give higher beta to?

• Alcohol
• Luxury watches
• Spa services
• Branded Jeans
• Underwear SageOne: Quest for Outstanding Investments 72
Small Firm and Illiquidity Risk Premium
• It is common practice to add premiums on to the cost of equity for firm-
specific characteristics. For instance, many analysts add a small stock
premium of 3-3.5% (historical premium for small stocks over the market) to
the cost of equity for smaller companies.
• Adding arbitrary premiums to the cost of equity is always a dangerous

exercise. If small stocks are riskier than larger stocks, we need to specify
the reasons and try to quantify them rather than trust historical averages.
(You could argue that smaller companies are more likely to serve niche
(discretionary) markets or have higher operating leverage and adjust the
beta to reflect this tendency).

From Cost of Equity to Cost of Capital

Valuation of Net Debt
Market Value is PV of future cash flow by discounting at current yield on

the debt or interest rate charged by the debtors for new debt
• The rating for a firm can be estimated using the financial characteristics of
the firm. In its simplest form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
If rates are not available for the specific company, use comparison of this ratio
with comparable companies having known interest rates or spread

Weights for the Cost of Capital Computation
• The weights used to compute the cost of capital should be the market value
weights for debt and equity.
• There is an element of circularity that is introduced into every valuation by

doing this, since the values that we attach to the firm and equity at the end
of the analysis are different from the values we gave them at the beginning.
• For private companies, neither the market value of equity nor the market
value of debt is observable. Rather than use book value weights, you
should try
– Industry average debt ratios for publicly traded firms in the business
– Target debt ratio (if management has such a target)
– Estimated value of equity and debt from valuation (through an iterative process)
Estimating Forecast Period in a DCF
(Period of Superior Returns)

When will the firm reach stable growth?
• Size of the firm
– Success usually makes a firm larger. As firms become larger, it becomes much
more difficult for them to maintain high growth rates
• Current growth rate
– While past growth is not always a reliable indicator of future growth, there is a
correlation between current growth and future growth. Thus, a firm growing at
30% currently probably has higher growth and a longer expected growth period
than one growing 10% a year now.
• Barriers to entry and differential advantages
– Ultimately, high growth comes from high project returns, which, in turn, comes
from barriers to entry and differential advantages.
– The question of how long growth will last and how high it will be can therefore be
framed as a question about what the barriers to entry are, how long they will stay
up and how strong they will remain.
How do you create value?

Value Creation: Increase Cash Flows from Assets
in Place

Value Creation: Increase Expected Growth
Price Leader versus Volume Leader Strategies

Return on Capital = Operating Margin * Capital Turnover Ratio

Value creation: Building Competitive Advantages:
Increase length of the growth period

Value Creation: Reduce Cost of Capital

Investment and DCF
• If you pay the DCF generated price and the forecast turns out to be true,
you will make returns = COE
• Key in investment is to find stocks where market expects higher returns

than you do and over time markets expectations come down
– Can happen if you understand the business better than the market
• If ROCE turns out to be better than market expectations and you estimate it
better
• Same about growth
• If superior returns sustain for longer term than what market expects and you
estimate that period better, you make money
Bottom-line is you estimate the value creation factor better than market
Valuation Case Studies

Jubilant Foodworks – What’s wrong with this?

Jubilant Foodworks – What’s wrong with this?
FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20
NOPLAT 170 420 720 998 1,530 2,288 3,198 4,259 5,101 6,019 7,014 8,049
Reinvestment (361) (260) (398) (467) (150) (272) (167) (228) (335) (353) 40 (634)
FCF (191) 160 322 531 1,380 2,016 3,031 4,031 4,766 5,666 7,054 7,415
Reinvestment
Rate 212% 62% 55% 47% 10% 12% 5% 5% 7% 6% -1% 8%
NOPLAT Growth 147% 71% 39% 53% 50% 40% 33% 20% 18% 17% 15%
Implied ROCE 69% 115% 70% 114% 505% 335% 635% 369% 274% 282%

Jubilant Foodworks – Constraints to Growth?
• Termination of master franchise agreement or higher franchise fee. Agreement until
2024 and renewable by 10 years. Royalty fees could increase from 3%. Can we
assume this to be perpetual?
• Competition could get aggressive. Pizza Hut has announced opening up 270 new
stores by 2015.
• Slowdown in store expansion rate. Estimate to reach 700 from 400 currently in the
next 8 years. i.e. growth CAGR of 7.2%
• “Same store sales growth” could slow. Long-term trend should be < Nominal GDP
• Increasing density of stores could cannibalize sales? Can new stores be as
profitable?
• Can margins be sustained with increasing raw material prices and increasing
salaries?
• Historical ROCE does not incorporate normalized expenses
– ESOPs calculated at intrinsic value
– Lease expenses not capitalized. Typically this reduces the ROCE
– Tax break expired SageOne: Quest for Outstanding Investments 88
Jubilant Foodworks – Positives for Growth
• Dunkin’ Donuts store growth rate higher than estimated. Current expectation of 80
stores in 5 years.
• Management able to sign more big master franchisee agreements.
• EBITDA margins expand above 19% currently (which management indicated are not
sustainable) driving ROCE higher.
• Smaller towns respond well and higher growth rate sustain over longer duration.

Jubilant Foodworks – Global Peers

Jubilant Foodworks – Global Peers

Jubilant Foodworks – Domestic FMCG Comps

Jubilant Foodworks – Implied Growth in current
price
• Current Price (June 11, 2012) = 1243/sh (Mcap of 8122 crs)
• FY13 PAT estimate = 143 crs
• Fwd PEx = 8122/143 = 56.7
• Sustainable ROE = 30%
• Stable growth fwd P/E (Exit) = .75/(13% - 7.5% ) = 13.6
• Higher return duration = 10 yrs
• Implied growth from FY12-21
– 37.3% (i.e. PAT growth of 17.7x in 9 years)
– If we isolate same store growth of 13%, store growth = 24.3% per

year i.e. 7x
Take Solutions
• Mcap = 430 crs (Sept’12)
• PAT FY12 = 94 crs
• Trailing PE x = 4.6
• P/B x = 1.25
• ROE = 25% in FY12 and 27% in FY11
• Avg ROE = 30% over past 6 years.
• 5% stake bought by Ashish Dhawan (ChrysCapital)
• Isn’t this company valuation too good to be true? What’s the catch?

Practical Approach to Multiples

Let’s try to determine Current P/E multiples to
following companies
PEx = Payout Ratiot+1/(r-g) where

- r is the expected return on equity
- g is the terminal growth rate in equity
Company r g
HDFC Bank
Coromandel Intl
Mangalam
Cement

Other Valuations

Facebook
98
Valuation in M&A

The Value of Synergy
• Synergy can be valued. In fact, if you want to pay for it, it should be valued.
• To value synergy, you need to answer two questions:

(a) What form is the synergy expected to take? Will it reduce costs as a
percentage of sales and increase profit margins (as is the case when there are
economies of scale)? Will it increase future growth (as is the case when there
is increased market power)? )
(b) When can the synergy be reasonably expected to start affecting cashflows?
(Will the gains from synergy show up instantaneously after the takeover? If it will
take time, when can the gains be expected to start showing up? )
• If you cannot answer these questions, you need to go back to the drawing
board…

Sources of Synergy

Valuing Synergy
(1) the firms involved in the merger are valued independently, by discounting
expected cash flows to each firm at the weighted average cost of capital for
that firm.
(2) the value of the combined firm, with no synergy, is obtained by adding
the values obtained for each firm in the first step.
(3) The effects of synergy are built into expected growth rates and
cashflows, and the combined firm is re-valued with synergy.
Value of Synergy = Value of the combined firm, with synergy - Value of the
combined firm, without synergy

Other items in DCF

Dealing with Operating Lease Expenses
• Operating Lease Expenses are treated as operating expenses in computing

operating income. In reality, operating lease expenses should be treated as
financing expenses, with the following adjustments to earnings and capital:
• Debt Value of Operating Leases = Present value of Operating Lease
Commitments at the pre-tax cost of debt
• When you convert operating leases into debt, you also create an asset to
counter it of exactly the same value.
• Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses -
Depreciation on Leased Asset
– As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of
Operating Leases.
Operating Leases at The Gap in 2003
• The Gap has conventional debt of about $ 1.97 billion on its balance sheet
and its pre-tax cost of debt is about 6%. Its operating lease payments in the
2003 were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
Debt Value of leases = $4,396.85 (Also value of leased asset)
• Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m

• Adjusted Operating Income = Stated OI + OL exp this year - Deprec’n
= $1,012 m + 978 m - 4397 m /7 = $1,362 million (7 year life for assets)
• Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m
The Collateral Effects of Treating Operating
Leases as Debt
Conventional Accounting Operating Leases Treated as Debt

Income Statement Income Statement
EBIT& Leases = 1,990 EBIT& Leases = 1,990
- Op Leases = 978 - Deprecn: OL= 628
EBIT = 1,012 EBIT = 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet Balance Sheet
Off balance sheet (Not shown as debt or as an Asset Liability
asset). Only the conventional debt of $1,970 OL Asset 4397 OL Debt 4397
million shows up on balance sheet Total debt = 4397 + 1970 = $6,367 million
Cost of capital = 8.20%(7350/9320) + 4% Cost of capital = 8.20%(7350/13717) + 4%

(1970/9320) = 7.31% (6367/13717) = 6.25%
Cost of equity for The Gap = 8.20%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970) Return on capital = 1362 (1-.35)/(3130+6367)
= 12.90% = 9.30%

R&D Expenses: Operating or Capital Expenses
• Accounting standards require us to consider R&D as an operating expense

even though it is designed to generate future growth. It is more logical to
treat it as capital expenditures.
• To capitalize R&D,
– Specify an amortizable life for R&D (2 - 10 years)
– Collect past R&D expenses for as long as the amortizable life
– Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5
years, the research asset can be obtained by adding up 1/5th of the R&D
expense from five years ago, 2/5th of the R&D expense from four years ago...:

Capitalizing R&D Expenses
R & D was assumed to have a 5-year life.
Year R&D Expense Unamortized portion Amortization this year
1999 (current) 1594.00 1.00 1594.00
1998 1026.00 0.80 820.80 $205.20
1997 698.00 0.60 418.80 $139.60
1996 399.00 0.40 159.60 $79.80
1995 211.00 0.20 42.20 $42.20
1994 89.00 0.00 0.00 $17.80
Total $ 3,035.40 $ 484.60
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1998 = $ 484.6 million
Adjustment to Operating Income = Quest

SageOne: $ 1,594 million - 484.6
for Outstanding million = 1,109.4 million
Investments 108
The Effect of Capitalizing R&D
Conventional Accounting R&D treated as capital expenditure
Income Statement Income Statement
EBIT& R&D = 5,049 EBIT& R&D = 5,049
- R&D = 1,594 - Amort: R&D = 485
EBIT = 3,455 EBIT = 4,564 (Increase of 1,109)
EBIT (1-t) = 2,246 EBIT (1-t) = 2,967
Ignored tax benefit = (1594-485)(.35) = 388
Adjusted EBIT (1-t) = 2967 + 388 = 3354 (Increase of
$1,109 million)
Net Income will also increase by $1,109 million
Balance Sheet Balance Sheet

Off balance sheet asset. Book value of equity at Asset Liability
$11,722 million is understated because biggest asset R&D Asset 3035 Book Equity +3035
is off the books. Total Book Equity = 11722+3035 = 14757
Capital Expenditures Capital Expenditures
Conventional net cap ex of $98 million Net Cap ex = 98 + 1594 – 485 = 1206
Cash Flows Cash Flows
EBIT (1-t) = 2246 EBIT (1-t) = 3354
- Net Cap Ex = 98 - Net Cap Ex = 1206
FCFF = 2148 FCFF = 2148
Return on capital = 2246/11722 (no debt) Return on capital = 3354/14757
= 19.16% = 22.78%

What tax rate?
• The tax rate that you should use in computing the after-tax operating
income should be
The effective tax rate in the financial statements (taxes paid/Taxable income)
The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
The marginal tax rate for the country in which the company operates
The weighted average marginal tax rate across the countries in which the
company operates
None of the above
Any of the above, as long as you compute your after-tax cost of debt using the
same tax rate

Capital expenditures should include
• Research and development expenses, once they have been re-categorized

as capital expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D
expenses - Amortization of Research Asset
• Acquisitions of other firms, since these are like capital expenditures. The
adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms -
Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of
acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually
categorized under other investment activities

Working Capital Investments
• In accounting terms, the working capital is the difference between current

assets (inventory, cash and accounts receivable) and current liabilities
(accounts payables, short term debt and debt due within the next year)
• A cleaner definition of working capital from a cash flow perspective is the
difference between non-cash current assets (inventory and accounts
receivable) and non-debt current liabilities (accounts payable)
• Any investment in this measure of working capital ties up cash. Therefore,
any increases (decreases) in working capital will reduce (increase) cash
flows in that period.
• When forecasting future growth, it is important to forecast the effects of
such growth on working capital needs, and building these effects into the
cash flows.

1. An Exercise in Cash Valuation
Company A Company B Company C
Enterprise Value 1 billion 1 billion 1 billion
Cash 100 mil 100 mil 100 mil
Return on Capital 10% 15% 22%
Cost of Capital 15% 15% 12%

Cash: Discount or Premium?

Dealing with Holdings in Other firms
• Holdings in other firms can be categorized into
– Minority passive holdings, in which case only the dividend from the holdings is
shown in the balance sheet
– Minority active holdings, in which case the share of equity income is shown in the
income statements
– Majority active holdings, in which case the financial statements are consolidated.
• We tend to be sloppy in practice in dealing with cross holdings. After valuing

the operating assets of a firm, using consolidated statements, it is common
to add on the balance sheet value of minority holdings (which are in book
value terms) and subtract out the minority interests (again in book value
terms), representing the portion of the consolidated company that does not
belong to the parent company.
How to value holdings in other firms.. In a perfect
world..
• In a perfect world, we would strip the parent company from its subsidiaries
and value each one separately. The value of the combined firm will be
– Value of parent company + Proportion of value of each subsidiary
• To do this right, you will need to be provided detailed information on each

subsidiary to estimated cash flows and discount rates.

Two compromise solutions…
• The market value solution: When the subsidiaries are publicly traded, you
could use their traded market capitalizations to estimate the values of the
cross holdings. You do risk carrying into your valuation any mistakes that
the market may be making in valuation.
• The relative value solution: When there are too many cross holdings to
value separately or when there is insufficient information provided on cross
holdings, you can convert the book values of holdings that you have on the
balance sheet (for both minority holdings and minority interests in majority
holdings) by using the average price to book value ratio of the sector in
which the subsidiaries operate.

Other Assets that have not been counted yet..
• Unutilized assets: If you have assets or property that are not being utilized
(vacant land, for example), you have not valued it yet. You can assess a
market value for these assets and add them on to the value of the firm.
• Overfunded pension plans: If you have a defined benefit plan and your
assets exceed your expected liabilities, you could consider the over funding
with two caveats:
– Collective bargaining agreements may prevent you from laying claim to these
excess assets.
– There are tax consequences. Often, withdrawals from pension plans get taxed at
much higher rates.
Do not double count an asset. If you count the income from an asset in your
cashflows, you cannot count the market value of the asset in your value.
A Discount for Complexity: An Experiment
Company A Company B
Operating Income 1 billion 1 billion
Tax rate 40% 40%
ROCE 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Business Multiple Businesses
Holdings Simple Complex
Accounting Transparent Opaque
• Which firm would you value more highly?

Brand name, great management, superb product
…Are we short changing the intangibles?
• There is often a temptation to add on premiums for intangibles. Among
them are
– Brand name
– Great management
– Loyal workforce
– Technological prowess
• There are two potential dangers:

– For some assets, the value may already be in your value and adding a
premium will be double counting.
– For other assets, the value may be ignored but incorporating it will not be
easy.
Relative Valuation

PE Ratio: Understanding the Fundamentals
• To understand the fundamentals, start with a basic equity discounted cash
flow model.
• With the dividend discount model,
DPS1 P0 Payout Ratio * (1 + g n )

P0 = = PE =
r − gn EPS 0 r-gn
• Dividing both sides by the current earnings per share,
• If this had been a FCFE Model,

FCFE 1 P0 (FCFE/Earnings)* (1+ g n )
P0 = = PE =
r − gn EPS0 r-g n
Conventional usage…
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized
earnings
Growth firms PEG ratio Big differences in growth
rates
Young growth firms w/ Revenue Multiples What choice do you have?
losses
Infrastructure EV/EBITDA Early losses, big DA
REIT P/CFE (where CFE = Net Big depreciation charges
income + Depreciation) on real estate
Financial Services Price/ Book equity Marked to market?

Retailing Revenue multiples Margins equalize sooner
or later

The Reasons for the allure…
“If you think I’m crazy, you should see the guy who lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode
“ A little inaccuracy sometimes saves tons of explanation”
H.H. Munro
“ If you are going to screw up, make sure that you have lots of company”
Ex-portfolio manager

The Essence of relative valuation?
• In relative valuation, the value of an asset is compared to the values
assessed by the market for similar or comparable assets.
• To do relative valuation then,

– we need to identify comparable assets and obtain market values for these assets
– convert these market values into standardized values, since the absolute prices
cannot be compared This process of standardizing creates price multiples.
– compare the standardized value or multiple for the asset being analyzed to the
standardized values for comparable asset, controlling for any differences
between the firms that might affect the multiple, to judge whether the asset is
under or over valued

Relative valuation is pervasive…
• Most asset valuations are relative.
• Most equity valuations on Wall Street are relative valuations.
– Almost 85% of equity research reports are based upon a multiple and
comparables.
– More than 50% of all acquisition valuations are based upon multiples
– Rules of thumb based on multiples are not only common but are often the basis
for final valuation judgments.
• While there are more discounted cashflow valuations in consulting and
corporate finance, they are often relative valuations masquerading as
discounted cash flow valuations.
– The objective in many discounted cashflow valuations is to back into a number
that has been obtained by using a multiple.
– The terminal value in a significant number of discounted cashflow valuations is
estimated using a multiple.
The Market Imperative….
• Relative valuation is much more likely to reflect market perceptions and
moods than discounted cash flow valuation. This can be an advantage
when it is important that the price reflect these perceptions as is the case
when
– the objective is to sell a security at that price today (as in the case of an IPO)
– investing on “momentum” based strategies
• With relative valuation, there will always be a significant proportion of
securities that are under valued and over valued.
• Since portfolio managers are judged based upon how they perform on a
relative basis (to the market and other money managers), relative valuation
is more tailored to their needs
• Relative valuation generally requires less information than discounted cash
flow valuation (especially when multiples are used as screens)

The Four Steps to Deconstructing Multiples
• Define the multiple
– In use, the same multiple can be defined in different ways by different users.
When comparing and using multiples, estimated by someone else, it is critical
that we understand how the multiples have been estimated
• Describe the multiple
– Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it is
too high or low.
• Analyze the multiple
– It is critical that we understand the fundamentals that drive each multiple, and the
nature of the relationship between the multiple and each variable.
• Apply the multiple
– Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.

Descriptive Tests
• What is the average and standard deviation for this multiple, across the
universe (market)?
• What is the median for this multiple?

– The median for this multiple is often a more reliable comparison point.
• How large are the outliers to the distribution, and how do we deal with the
outliers?
– Throwing out the outliers may seem like an obvious solution, but if the outliers all
lie on one side of the distribution (they usually are large positive numbers), this
can lead to a biased estimate.
• Are there cases where the multiple cannot be estimated? Will ignoring these
cases lead to a biased estimate of the multiple?
• How has this multipleSageOne:

changedQuestover time? Investments
for Outstanding
Analytical Tests
• What are the fundamentals that determine and drive these multiples?
– Proposition 2: Embedded in every multiple are all of the variables that drive every
discounted cash flow valuation - growth, risk and cash flow patterns.
– In fact, using a simple discounted cash flow model and basic algebra should
yield the fundamentals that drive a multiple
• How do changes in these fundamentals change the multiple?

– The relationship between a fundamental (like growth) and a multiple (such as
PE) is seldom linear. For example, if firm A has twice the growth rate of firm B, it
will generally not trade at twice its PE ratio
– Proposition 3: It is impossible to properly compare firms on a multiple, if

we do not know the nature of the relationship between fundamentals and
the multiple.
A Real Option Premium
• In the last few years, there are some who have argued that discounted
cashflow valuations under valued some companies and that a real option
premium should be tacked on to DCF valuations. To understanding its
moorings, compare the two trees below:
A bad investment………………….. Becomes a good one..
1. Learn at relatively low cost

2. Make better decisions based on learning

Three Basic Questions
• When is there a real option embedded in a decision or an asset?
• When does that real option have significant economic value?
• Can that value be estimated using an option pricing model?

When is there an option embedded in an action?
• An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or an
exercise price) at or before the expiration date of the option.
• There has to be a clearly defined underlying asset whose value changes

over time in unpredictable ways.
• The payoffs on this asset (real option) have to be contingent on an specified

event occurring within a finite period.

Payoff Diagram on a Call
Net Payoff
on Call
Strike
Price
Price of underlying asset

Example 1: Product Patent as an Option
PV of Cash Flows
from Project
Initial Investment in
Project
Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section

Example 2: Undeveloped Oil Reserve as an option
Net Payoff on
Extraction
Cost of Developing
Reserve
Value of estimated reserve of

natural resource

Example 3: Expansion of existing project as an
option
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Present Value of Expected

Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section

When does the option have significant economic
value?
• For an option to have significant economic value, there has to be a
restriction on competition in the event of the contingency. In a perfectly
competitive product market, no contingency, no matter how positive, will
generate positive net present value.
• At the limit, real options are most valuable when you have exclusivity - you
and only you can take advantage of the contingency. They become less
valuable as the barriers to competition become less steep.

Exclusivity: Putting Real Options to the Test
• Product Options: Patent on a drug
– Patents restrict competitors from developing similar products
– Patents do not restrict competitors from developing other products to treat the
same disease.
• Natural Resource options: An undeveloped oil reserve or gold mine.

– Natural resource reserves are limited.
– It takes time and resources to develop new reserves
• Growth Options: Expansion into a new product or market

– Barriers may range from strong (exclusive licenses granted by the government -
as in telecom businesses) to weaker (brand name, knowledge of the market) to
weakest (first mover).

Determinants of option value
• Variables Relating to Underlying Asset
– Value of Underlying Asset; as this value increases, the right to buy at a fixed
price (calls) will become more valuable and the right to sell at a fixed price (puts)
will become less valuable.
– Variance in that value; as the variance increases, both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
– Expected dividends on the asset, which are likely to reduce the price
appreciation component of the asset, reducing the value of calls and increasing
the value of puts.
• Variables Relating to Option
– Strike Price of Options; the right to buy (sell) at a fixed price becomes more
(less) valuable at a lower price.
– Life of the Option; both calls and puts benefit from a longer life.
• Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed
price in the future becomes more (less) valuable.

The Building Blocks for Option Pricing Models:
Arbitrage and Replication
• The objective in creating a replicating portfolio is to use a combination of
riskfree borrowing/lending and the underlying asset to create the same
cashflows as the option being valued.
– Call = Borrowing + Buying ∆ of the Underlying Stock
– Put = Selling Short ∆ on Underlying Asset + Lending
– The number of shares bought or sold is called the option delta.
• The principles of arbitrage then apply, and the value of the option has to be
equal to the value of the replicating portfolio.

The Binomial Option Pricing Model

Valuing an Oil Reserve
• Consider an offshore oil property with an estimated oil reserve of 50 million
barrels of oil, where the cost of developing the reserve is $ 600 million
today.
• The firm has the rights to exploit this reserve for the next twenty years and
the marginal value per barrel of oil is $12 per barrel currently (Price per
barrel - marginal cost per barrel). There is a 2 year lag between the decision
to exploit the reserve and oil extraction.
• Once developed, the net production revenue each year will be 5% of the
value of the reserves.
• The riskless rate is 8% and the variance in ln(oil prices) is 0.03.

Valuing an oil reserve as a real option
• Current Value of the asset = S = Value of the developed reserve discounted
back the length of the development lag at the dividend yield = $12 * 50
/(1.05)2 = $ 544.22
• (If development is started today, the oil will not be available for sale until two
years from now. The estimated opportunity cost of this delay is the lost
production revenue over the delay period. Hence, the discounting of the
reserve back at the dividend yield)
• Exercise Price = Present Value of development cost = $12 * 50 = $600
million
• Time to expiration on the option = 20 years
• Variance in the value of the underlying asset = 0.03
• Riskless rate =8%
• Dividend Yield = NetSageOne:
production revenue
Quest for / Value
Outstanding of reserve = 5%
Investments
Valuation Example: Banks

Valuation Example: Banks

References Used
• References and data used:

– Book: Damodaran on Valuation written by Prof. Aswath Damodaran, NYU
Stern
– Presentations by Prof. Aswath Damodaran
– Valuation: Measuring and Managing the Value of Companies by McKinsey &
Company Inc.
My Goal
• Help understand core fundamentals of valuation and its drivers
• Help avoid gross mistakes in valuation assumptions
• Provide practical method to value a firm

Valuation Presentation at Flame Institute June 2014 PDF

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Lecture at Flame Institute on Valuation by

Samit Vartak, CFA

Investment Advisors LLP

SageOne: Quest for Outstanding Investments

• Its not impossible to tell whether current price is a bargain

SageOne: Quest for Outstanding Investments 3

SageOne: Quest for Outstanding Investments 4

SageOne: Quest for Outstanding Investments 5

Cash 5 Accounts Payables 40

SageOne: Quest for Outstanding Investments 6

Cash 5 Accounts Payables 40

SageOne: Quest for Outstanding Investments 7

SageOne: Quest for Outstanding Investments 8

• Relative Valuation (very briefly), estimates the value of an asset by looking

What valuation method do you use for your personal investments?

Coupon (interest paid) 10% 10.00 10.00 10.00 10.00 10.00

Expected Return 10% 0.91 0.83 0.75 0.68 0.62

CF1 CF2 CF3 CF4 CFn

Interest (coupon unpaid) 10% 10.00 11.00 12.10 13.31 14.64

Expected Return 10% 0.91 0.83 0.75 0.68 0.62

SageOne: Quest for Outstanding Investments 11

Present Value 83.24

Present Value 107.99

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PAT 10% 10.00 10.00 10.00 10.00 10.00

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PAT 15% 15.00 16.13 17.33 18.63 20.03

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Money invested at returns < expected returns

SageOne: Quest for Outstanding Investments 15

SageOne: Quest for Outstanding Investments 16

PAT 10% 10.00 10.00 10.00 10.00 10.00

SageOne: Quest for Outstanding Investments 17

PAT 10% 10.00 10.50 11.03 11.58 12.16

PAT 15% 15.00 15.00 15.00 15.00 15.00

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PAT 15% 15.00 16.13 17.33 18.63 20.03

- PAT CAGR = 7.5%

SageOne: Quest for Outstanding Investments 20

PAT 20% 20.00 20.00 20.00 20.00 20.00

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PAT 20% 20.00 22.00 24.20 26.62 29.28

- PAT CAGR = 10%

SageOne: Quest for Outstanding Investments 22

PAT 20% 20.00 24.00 28.80 34.56 41.47

- PAT CAGR = 20%

SageOne: Quest for Outstanding Investments 23

Growth will increase value ONLY IF the returns

SageOne: Quest for Outstanding Investments 24

ROCE 10% 10% 15% 15% 10%

Ending Capital 110.00 121.00 139.15 160.02 176.02

Present Value 100.00 100.00 104.55 109.30 109.30

SageOne: Quest for Outstanding Investments 25

• Valuation of all businesses peak at some finite time

SageOne: Quest for Outstanding Investments 26

Size (Mcap/Sales) of the company • Regional or national

Who are the investors • What's their opportunity cost

Investment horizon • Are the investors investing for a

SageOne: Quest for Outstanding Investments 27

Year 1 Year 2 Year 3 Year 4 Year 5 CAGR

Nifty 25% 25% 25% 25% -25% 12.9%

Company 1 40% 40% 40% 40% -60% 9.0%

Company 2 25% 25% 25% 25% -20% 14.3%