Security Valuation

Session 3 & 4

Approaches to Valuation
[Chapter 2]
 Approaches to Valuation
Objective of DCF: To find the value of assets,
given their Cash Flow, Growth & Risk characteristics
Dividend 1. Gordon Growth Model
Equity Valuation 2. 2-Stage Growth Model
models 3. H-Model
FCFE 4. 3-Stage Growth Model
I. Discounted Cash
flow
(DCF)Model COC approach

Firm Valuation
APV approach
models

Excess Return III. Contingent

(EVA) model Claim Valuation
Valuation Models
Earnings IV. Asset- Based
Multiples Valuation Model

Book Value
II. Relative Valuation Multiples
(RV) Model
Revenue
Multiples

Sector specific
Multiples

Objective of RV: Value of an assets is based on how

similar assets are currently priced in the market.
I. Discounted Cash Flow (DCF) Valuation
 What is (DCF) Valuation?
❑ What is it: In discounted cash flow valuation, the value of an asset is the
present value (PV) of the expected cash flows on the asset.

t = n CF
Value =  t where :
n = Life of the asset

t CFt = Cash flow in period t

t =1 (1+ r)
r = Discount rate reflecting the riskiness

❑ Philosophical Basis: Every asset has an intrinsic value that can be

estimated, based upon its characteristics in terms of cash flows, growth and
risk.

❑ What is intrinsic value? It is the value that would be attached to the firm
by an unbiased analyst, who not only estimates the expected cash flows for
the firm correctly, given the information available at the time, but also attaches
the right discount rate to value these cash flows.

❑ While market prices can deviate from intrinsic value (estimated based on
fundamentals), we hope that the two will converge sooner rather than later.
❑ 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.
 Key Inputs required for DCF Model
❑ Key Inputs required for DCF valuation models:

1. RISK : Appropriate Discount Rate

a) Equity Risk - COE

b) Firm Risk – COC or WACC

2. Free Cash Flow :

a) Equity CF- Adjust Earnings to find FCFE if Dividends not a

representative of Cash flow to Equity

b) Firm CF - Adjust Earnings to find FCFF

3. Growth Rate :

a) Growth rate for Equity = RR * ROE or Retention Ratio *ROE

b) Growth rate for the Entire Firm = RIR *ROC

4. Terminal Value (TV)

 Measuring Cash Flow to the Firm

Cash flow to the firm (FCFF) = Pre-debt Cash Flows

= EBIT ( 1 - tax rate)

- (Capital Expenditures - Depreciation)
Reinvestment Needs
- Change in non-cash Working Capital
 Measuring Cash Flow to the Equity

1. Cash flow to the Equity (FCFE) = After–debt Cash Flows

= Net Income
- (Capital Expenditures - Depreciation)
Reinvestment Needs
- Change in non-cash Working Capital
- (Principal Repaid – New Debt Issues)
[If preferred stock exist, preferred dividends will also need to be netted out]

Or

2. Cash flow to the Equity (FCFE) = Dividends + Stock Buybacks

 Dividends and Cash Flows to Equity

• In the strictest sense, the only cash flow that an investor will receive from an equity
investment in a publicly traded firm is the dividend that will be paid on the stock.

• Actual dividends, however, are set by the managers of the firm and may be much lower
than the potential dividends (that could have been paid out)
• managers are conservative and try to smooth out dividends
• managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities

Actual Dividends < Potential Dividends

When actual dividends are less than potential dividends, using a model that focuses
only on dividends will under state the true value of the equity in a firm.

In such cases - DO NOT use DDM model for DCF-Equity Valuation rather use
FCFE Model for DCF- Equity Valuation .
 DCF Models for Equity Valuation
1. FCFE : The value of equity is obtained by discounting expected
Cash flows to equity, i.e., the residual cash flows after meeting all
expenses, reinvestment needs, tax obligations and interest and
principal payments, at the cost of equity, i.e., the rate of return required
by equity investors in the firm.
t=n
CF to Equity t
Value of Equity =  (1+ k e )t
t=1

where:
CF to Equity t = Expected Cash flow to Equity in period t
ke = Cost of Equity
n = Life of the asset

2. DDM : The dividend discount model (DDM) is a specialized case of

equity valuation, and the value of a stock is the present value of
expected future dividends.
 DCF Models for Firm Valuation

1. Cost of capital (COC) approach: The value of the firm is obtained

by discounting expected cash flows to the firm, i.e., the residual
cash flows after meeting all operating expenses and taxes, but prior
to debt payments, at the weighted average cost of capital, which is
the cost of the different components of financing used by the firm,
weighted by their market value proportions.
t=n
CF to Firm t
Value of Firm =  t
t=1 (1+ WACC)
where,
n = Life of the asset
CF to Firm t = Expected Cash flow to Firm in period t
WACC = Weighted Average Cost of Capital
Cost of capital (COC) approach: In the COC approach, we capture the
effects of debt in the discount rate.

COC = COE (proportion of equity used to fund business)

+ Pretax COD (1-tax rate) ((proportion of debt used to fund business)

• The Cash Flows discounted are pre-debt cash flows and do not
include any tax benefits of debt (since it would lead to double counting)

• Effects of using debt on value :

1. Positive effect - Tax deductibility of interest expenses provides a
tax subsidy or benefit to the firm
2. Negative effect - Debt increases the likelihood that the firm will
default on its commitments and be forced into bankruptcy
2. Adjusted Present Value (APV) approach:

Firm Value = Unlevered Firm Value

(or Value of business with 100% equity financing)
+ PV of expected tax benefits of debt
- Expected Bankruptcy Cost

• In APV approach, we separate the effects on value of debt

financing from the value of the assets of a business

• We start by valuing the business as if it were all equity funded

• Assess the effect of debt separately, by first valuing the tax

benefits from the debt and the subtracting out the expected
bankruptcy costs
 COC Approach vs. APV Approach
In APV Valuation, Value of a levered firm is obtained by adding the net benefit of debt to an
unlevered firm value.
In COC approach, the effects of leverage shows up in the COC or WACC with the tax benefit
incorporated in the after-tax COD and the bankruptcy costs in both the levered beta and pretax
COD.
Will the two approaches yield the same value ?
Not necessarily
Reason 1: Models consider Bankruptcy costs very differently. APV provides more flexibility in
allowing you to consider indirect bankruptcy costs, to the extent that these costs do not show up
or show up inadequately in pretax COD.
Reason 2: APV considers tax benefit from dollar debt value based on existing debt. COC
approach estimates the tax benefit from a debt ratio that may require a firm to borrow increasing
amounts in the future.
E.g., Assuming market debt-to-capital ratio of 30% in perpetuity for a growing firm will require it to
borrow more in the future and tax benefit from expected future borrowings is incorporated into
value today.

COC approach is more practical choice when valuing ongoing firms and it not going through
contortions on financial leverage; it is easier to work with debt ratio than with dollar-debt levels.
APV approach is more useful for transactions that are funded disproportionately with debt
and where debt repayment schedules are negotiated or known (so it has acquired a footing
in LBO circles)
3. Excess Return or Economic Value Added (EVA) model :

Excess Return = Cash flow earned – (COC * Capital invested in asset)

Firm Value = Capital Invested + Present value of excess returns

• In excess return (and excess cash flow) models, only cash flows
earned in excess of the required return are viewed as value creating

• The present value of these excess cash flows can be added on to the
amount invested in the asset to estimate its value
 Problem 1
Assume that you are analyzing a company with the following cashflows
for the next five years. Assume also that the cost of equity is 13.625%
and the firm can borrow long term at 10%. (The tax rate for the firm is
50%.) The current market value of equity is $1,073 and the value of
debt outstanding is $800.

Answer the following Questions

1) Estimate the cost of capital.
2) What is the value of equity in this firm?
3) What is the value of the firm?
 Solution 1
Given: Cost of Equity(COE) is given as an input and is 13.625%
After-tax cost of debt is 5% [Cost of Debt = Pre-tax rate (1 – tax rate) = 10% (1-.5) = 5%]

Given the MV of equity($1073) and debt ($800) , we can estimate the cost of capital(COC)

WACC = Cost of Equity (Equity / (Debt + Equity)) + Cost of Debt (Debt/(Debt + Equity))
= 13.625% (1073/1873) + 5% (800/1873) = 9.94%

Method 1: Discount Cash Flows to Equity at Cost of Equity to get value of equity
We discount cash flows to equity at the cost of equity:

PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254

+ (83.49+1603)/1.136255 = $1073

Method 2: Discount Cash Flows to Firm at Cost of Capital to get value of firm
PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944
+ (123.49+2363)/1.09945 = $1873

Thus, alternatively PV of Equity = PV of Firm – Market Value of Debt

= $ 1873 – $ 800 = $1073

Note that the value of equity is $1073 under both approaches.

It is easy to make the mistake of discounting cashflows to equity at the COC or
the cashflows to the firm at the COE.

Error 1: Discount Cash Flows to Equity at Cost of Capital to get too high a value for
equity

PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944

+ (83.49+1603)/1.09945 = $1248

Error 2: Discount Cash Flows to Firm at Cost of Equity to get too low a value for the
firm
PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254
+ (123.49+2363)/1.136255 = $1613

PV of Equity = PV of Firm – Market Value of Debt

= $1612.86 – $800 = $813

Note : The effects of using the wrong discount rate are clearly visible in the last two
calculations. When the cost of capital is mistakenly used to discount the cashflows to
equity, the value of equity increases by $175 ($1248 - $1073) over its true value
($1073).

When the cashflows to the firm are erroneously discounted at the cost of equity, the
value of the firm is understated by $260 ($1873 -$1613).
 Problem 2
Assume that you have an asset in which you invest $100 million
and that you expect to generate $12 million per year in after-tax
cash flows in perpetuity. Assume further that the cost of capital
on this investment is 10%.

What is the value of the asset using :

• 1)Total cash flow model
• 2) Excess return model (EVA)
 Solution 2
1) With a total cash flow model, the value of this asset can be estimated as
follows:

Value of asset = $12 million/0.10 = $120 million

2) With an excess return model, we would first compute the excess return made
on this asset:

Excess return = Cash flow earned – (Cost of capital * Capital Invested in asset)
= $12 million – (0.10 * $100) million = $2 million

We then add the present value of these excess returns to the investment in the
asset:

Value of asset = Present value of excess return + Investment in the asset

= $2 million/0.10 + $100 million = $120 million
 Solution 2

Answers in the two approaches are equivalent.

Why, then, would we want to use an excess return model?

By focusing on excess returns, this model brings home the point that it
is not earnings per se that create value, but earnings in excess of a
required return.
 Problem 3 - Valuing a firm with the COC approach:
Tube Investments of India (TI) in stable growth

Tube Investments of India is a diversified manufacturing firm, with its headquarters in

South India. In 1999, the firm reported operating income of Rs. 632.2 million and paid
faced a tax rate of 30% on income. The firm had a book value of equity of Rs 3432.1
million rupees and book value of debt of Rs. 1377.2 million at the end of 1998.
(existing debt outstanding of Rs 1807.3 million)

The firm’s return on capital can be estimated as follows:

ROC = EBIT(1-t) /( B.V of EQ + B.V of Debt)
=632.2 (1 − 0.30) / (3432.1+ 1377.2) =9.20%

Analysis wrt ROC : The firm is in stable businesses and expects to grow only 5% a
year. Assuming that it maintains its current return on capital, the Reinvestment Rate (RR)
for the firm will be:

Growth rate (of the entire firm) = RR * ROC

RR = 5% / 9.20% = 54.34%
 Problem 3 - Valuing a firm with the COC approach:
Tube Investments of India (TI) in stable growth

The firm’s expected free cash flow to the firm next year can be estimated as follows:

Expected EBIT (1-t) next year = [EBIT (1-t)*g] = [632.2 (1- 0.30)] (1.05) = 464.7
- Expected Reinvestment next year = EBIT(1-t) (Reinvestment rate)
= 464.7 (0.5435) = 252.5
Expected Free Cash flow to the firm = 212.2

With the perpetual growth of 5%, the expected free cash flow to the firm shown
above (Rs 212.2 million) and the cost of capital of 15.60%, we obtain a value for the
firm of:

Value of the operating assets of firm = 212.2 / (0.156 - 0.05) = Rs 2002 million

Adding back cash and marketable securities with a value of Rs 1365.3 million

Value of the firm = Rs. 3367.3 million

subtracting out the debt outstanding of Rs 1807.3 million yields

Value of EQ = Rs 1560 million
 Problem 3 - Valuing a firm with the APV approach:
Tube Investments
Here, we re-estimate the value of the firm using an Adjusted Present Value (APV)
approach in three steps.

Step 1: Unlevered firm value

To estimate the unlevered firm value, we first compute the unlevered beta.
Tube Investment’s beta is 1.17, its current market debt to equity ratio is 79% and the
firm’s tax rate is 30%.
βL =βu [1 + (1-t)D/E]
βu = βL / [1 + (1-t)D/E]

Unlevered beta = 1.17/ [1+(1- 0.3)(0.79)]= 0.75

Using the rupee risk-free rate of 10.5% and the risk premium of 9.23% for India, we
estimate an unlevered cost of equity.

Unlevered cost of equity = 10.5% + 0.75(9.23%) = 17.45%

Using the free cash flow to the firm of Rs 212.2 million and the stable growth rate of 5%,
we estimate the unlevered firm value

Unlevered firm value = 212.2 / (0.1745-0.05) = Rs. 1704.6 million

 Problem 3 - Valuing a firm with the APV approach:
Tube Investments
Step 2: Tax benefits from debt

The tax benefits from debt are computed based upon Tube Investment’s existing dollar
debt of Rs.1807.3 million and the tax rate of 30%:

Expected tax benefits in perpetuity = Tax rate (Debt) = 0.30 (1807.3) = Rs 542.2 million

Step 3: Expected bankruptcy costs

To estimate this, we made two assumptions.

• First, based upon its existing rating, the probability of default at the existing debt
level is 10%.
• Second, the cost of bankruptcy is 40% of unlevered firm value.

Expected bankruptcy cost =Probability of bankruptcy * Cost of bankruptcy *

Unlevered firm value = 0.10*0.40*1704.6 = Rs 68.2 million

The value of the operating assets of the firm can now be estimated.
Value of the operating assets = Unlevered firm value + PV of tax benefits – Expected
Bankruptcy Costs
= 1704.6 + 542.2 – 68.2 = Rs 2178.6 million
 Problem 3 - Valuing a firm with the APV approach:
Tube Investments

Adding to this the value of cash and marketable securities of Rs. 1365.3 million, we
obtain a value for the firm of Rs 3543.9 million under APV approach.

In contrast, we valued the firm at Rs. 3367.3 million with the COC (cost of capital)
approach.
Applications and Limitations : DCF Valuation
• DCF valuation is based upon expected future cashflows and discount
rates.

• This approach is easiest to use for assets (firms)

• whose cashflows are currently positive and can be estimated with
some reliability for future periods and
• where a proxy for risk that can be used to obtain discount-rate is
available

• Scenarios where DCF valuation might run into trouble and need to be
adapted :
• Firms in trouble
• Cyclical Firms
• Firms with unutilized assets
• Firms in the process of restructuring
• Firms involved in acquisitions
• Private Firms
DCF Approach – Summary when growth rate is constant
Equity Valuation Firm Valuation
II. Relative Valuation (RV)
 What is Relative Valuation (RV) ?
❑ What is it?: The value of any asset can be estimated by looking at how the
market prices value “similar” or ‘comparable” assets.

❑ Philosophical Basis: The intrinsic value of an asset is impossible (or close to

impossible) to estimate. 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 (in equity, this is obtained by dividing the
price by a common variable, such as earnings or book value)
• 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.
Multiples are just standardized estimates of price

I/S B/S
Multiples are just standardized estimates of price
• Numerator : The distinction between
– Price (representing equity value) and
– Firm value (representing the combined market value of equity and
debt) and
– Enterprise Value or Value of Operating Assets (representing firm
value - cash and marketable securities) should be noted.

• Why is Cash netted out ? EV/EBITDA - Since interest income from cash
is not counted as part of EBITDA, not netting it out will result in an
overstatement of the multiple.

• Denominator can be a number from the

– Income Statement (revenues, earnings) or
– From Balance Sheet (book value).
– It can even be a non-financial input (number of employees or units of
the product produced).
 Relative Valuation is pervasive…

❑ Most valuations done are relative valuations.

• Almost 85% of equity research reports are based upon a multiple
and comparable.
• 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.
So, you believe only in intrinsic value? Here’s why you
should still care about relative value

❑ Even if you are a true believer in DCF valuation, presenting your

findings on a relative valuation basis will make it more likely that your
findings/recommendations will reach a receptive audience.

❑ In some cases, relative valuation can help find weak spots in

discounted cash flow valuations and fix them.

❑ The problem with multiples is not in their use but in their abuse. If we
can find ways to frame multiples right, we should be able to use them
better.
 Need for Standardization of Values
❑ Two components to RV :
1) To Value assets on relative basis – Prices have to be standardized – How ?
By converting Prices into Multiples of Earnings, Book Value or Sales.

Need to Standardize values and Multiples:

Price of a stock is a function of both Value of the equity in a company & No of

shares O/S in the firm.

Eg . 2-for-1 stock split that doubles the number of units will approximately half the stock
price.
Since stock prices are determined by the number of units of equity in a firm, stock
prices cannot be compared across different firms.

To compare the values of similar firms in the market- Need to standardize the values
in some way.

Values can be standardized : Relative to the

1) Earnings generated
2) Book value or replacement value of the assets employed,
3) Revenues generated, or
4) To measures that are specific to firms in a sector
 Comparable Firms

2) To find similar firms – difficult to do – since no firms are identical – firms

in the same business can still differ on risk, growth potential and cash flows.

❑ Comparable Firms:

i. General View/ Conventional practice and Not always True : Firms in the same
business/industry as the firm being valued are called comparable.

ii. Ideal View - A Comparable firm is one with cash flows, growth potential, and
risk similar to the firm being valued.

iii. Telecommunications firm can be compared to a software firm if the two are identical
in terms of cash flows, growth, and risk.

iv. Analysts define comparable firms to be other firms in the firm's business or
businesses. - Implicit assumption being made here is that firms in the same sector
have similar risk, growth, and cash flow profiles and therefore can be compared
with much more legitimacy
 Comparable Firms
❑ The key question faced in coming up with the list of comparable firms

1. How narrowly you define a comparable firm - If you define it as a firm that
looks just like the firm you are valuing on every dimension (risk, growth, and
cash flows) may find only a handful of comparable firms.

2. How broadly you define a comparable firm - If you define it more broadly
and are willing to accept differences on one or all of the dimensions -
comparable firm list will be longer.

No matter how carefully you construct your list of comparable firms - End up with
firms that are different from the firm you are valuing.

The differences may be small on some variables and large on others, and
you will have to control for these differences in a relative valuation.
Comparable Firms- Controlling for Differences
Question is

How to control for these differences, when comparing pricing across

several firms?

You will get more reliable estimates of relative value using a larger sample of
less comparable firms than a very small sample of more comparable ones.

There are three ways of controlling for these differences

I. Subjective adjustments
II. Modified multiples
III. Sector regressions
IV. Market regressions
 Stock Split
A stock split is a corporate action when a company divides the existing shares of
its stock into multiple new shares to boost the stock's liquidity.

The most common split ratios are 2-for-1 or 3-for-1, which means that the
stockholder will have two or three shares, respectively, for every share held earlier.

Basically, companies choose to split their shares so they can lower the trading
price of their stock to a range deemed comfortable by most investors and increase
liquidity of the shares.

Human psychology is - Most investors are more comfortable purchasing, say, 100
shares of $10 stock as opposed to 10 shares of $100 stock.

Thus, when a company's share price has risen substantially, most public firms
will end up declaring a stock split at some point to reduce the price to a more
popular trading price.

The number of shares outstanding increases by a specific multiple, the total dollar
value of the shares remains the same compared to pre-split amounts, because the
split does not add any real value.
 Stock Split
Example of a Stock Split

In June 2014, Apple (AAPL) split its shares 7-for-1 to make it more accessible to a
larger number of investors.

Right before the split, each share was trading at $645.57.

After the split, the price per share at market open was $92.70, which is
approximately 645.57 ÷ 7.

Existing shareholders were also given six additional shares for each share owned,
so an investor who owned 1,000 shares of AAPL pre-split would have 7,000 shares
post-split.

Apple's outstanding shares increased from 861 million to 6 billion shares, however,
the market cap remained largely unchanged at $556 billion.

The day after the stock split, the price had increased to a high of $95.05 to
reflect the increased demand from the lower stock price.
 III. Contingent Claim Valuation

Third approach to Valuation

• Assets with the characteristics of an option is valued using

an option pricing model

• In this case, cash flows are contingent on occurrence or

non-occurrence of an event
 IV. Asset- Based Valuation Models
Fourth approach to Valuation

• Values individual assets owned by a firm and uses that to

estimate its value – asset-based valuation models

• There are several variants on asset-based valuation models:

1. Liquidation value, which is obtained by aggregating the
estimated sale proceeds of the assets owned by a firm.
2. Replacement cost, where you evaluate what it would cost
you to replace all of the assets that a firm has today.

Do not consider this approach alternatives to DCF, RV or option

pricing model, since both replacement and liquidation values
have to be obtained using one or more of these approaches
 IV. Asset- Based Valuation Models
• Ultimately, all valuation models attempt to value assets- the
differences arise in how we identify the assets and how we
attach value to each asset

• In liquidation valuation, we look only at assets in place and

estimate their value based upon what similar assets are priced
at in the market

• In traditional discounted cash flow valuation, we consider all

assets including expected growth potential to arrive at value

• The two approaches may, in fact, yield the same values if you
have a firm that has no growth assets and the market
assessments of value reflect expected Cash Flows