Different Approaches to Valuation

8/3/2019 Different Approaches to Valuation

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K J SOMAIYA INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

A Discussion on the

Various Approaches to

ValuationA Seminar Paper

Pulkit Dev Lambah, PGDM Finance, Roll No 007

15/12/2010

Under The Guidance of

Prof. Jayendran

SIMSR

The objective of this research is to provide an overview about the different approaches used for valuing a firmand discussing the various methods within these approaches.


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CONTENTS

A Discussion on the Different Approaches to Valuation..................................................................................... 3

Discounted Cash Flow Approaches ............................................................................................................... 3

Dividend Discount Model .......................................................................................................................... 3

Free Cash Flow to Equity ........................................................................................................................... 4

Free Cash Flow To Firm ............................................................................................................................. 5

Relative Valuation Techniques ...................................................................................................................... 6

Price to Earnings ratio ............................................................................................................................... 6

Price to Book Value ratio .......................................................................................................................... 7

Price to Sales ratio .................................................................................................................................... 7

Price to Cash Flow ratio ............................................................................................................................ 8

Discounted Cash Flow V/S relative valuation Methods .................... ....................... ................. ...................... 9

Applicability of methods with respect to Scenario .................... ....................... ................. ......................... 9

Applicability Of Methods With Respect To Sector ................. ....................... .................. ....................... ... 10

Conclusions ................................................................................................................................................ 10

References ..................................................................................................................................................... 11


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A DI SCUSSION ON THE DIFFERENT APPROACHES TO VALUATION

Valuation can be considered the backbone of finance. It is widely used across all branches of finance, be it

corporate finance, portfolio management, equity analysis and many other fields. In corporate finance the

objective is to maximize firm value by altering financing, investment and dividend decisions. In portfolio

management, resources are spent to find undervalued firms and then a profit is sought to be made as prices

converge to market value. In studying efficient markets also, valuation is used to find out whether prices divert

from their true value, and if they divert, how soon do they revert. Hence, Understanding what determines the

value of a firm and how to estimate that value seems to be a prerequisite for making sensible decisions.

There are two broad approaches to valuation: - the relative valuation methods and the discounted cash flow

techniques. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets

relative to a common variable such as earnings, cash flows, book value or sales. Discounted cash flow

valuation, relates the value of an asset to the present value of expected future cash flows on that asset. This

discussion will focus on these two broad approaches and the techniques used within these approaches for

valuation of a company. This discussion will use Reliance Industries Limited as an example to elaborate each of

the valuation methods explained in the following sections.

DISCOUNTED CASH FLOW APPROACHES

In the discounted cash flow approaches, the value of the stock is estimated based upon the present value of

some measure of cash flow, including dividends, operating cash flows and free cash flows.

A potential drawback to these cash flow techniques is that they are very dependent on the two significant

inputs a) the growth rates of cash flows (both the rate of growth and duration of growth) and b) the estimate

of discount rates. A small change in either of these values can have a significant impact on the estimated value.

DIVIDEND DISCOUNT MODEL

When investors buy stock in publicly traded companies, they generally expect to get two types of cash flows

dividends during the holding period and an expected price at the end of the holding period. Since this

expected price is itself determined by future dividends, the value of a stock is the present value of dividends

through infinity.

The most straightforward measure of cash flows is dividends because these are cash flows that go directly to

the investor, which implies that we can use the cost of equity as the discount rate. The dividend discount

model (DDM) is relevant while valuing a firm that is stable, mature and has a relatively constant growth for the

long term. However, this dividend technique is difficult to apply to firms that do not pay dividends during

periods of high growth or that currently pay very limited dividends because they have high rate of return

investment alternatives available.

The DDMs main attraction to investors is its inherent simplicity and the fact that sometimes, dividends

represent the only cash flows from the firm that is tangible to investors. In addition, we need fewer

assumptions to get forecasted dividends than to forecast free cash flows. Another solid argument can be that

management sets the dividends at such a level that can be sustained even in the face of volatile earnings.

The DDM has its drawbacks that include firms either paying too much or too less in dividends than what they

have available in cash flows. If the dividends are too less than the cash flows of the firm, the FCFE increases the

dividends , cash balances are build up. The DDM undervalues the claim of equity shareholders on these cash


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balances. On the other hand, if firms pay much more dividends than what they have in cash reserves, funding

the gap with new debt or equity issues, the DDM generates an overly optimistic value estimate.

Firms in mature businesses with stable earnings try to calibrate their dividends with their cash flows. The DDM

can be useful in valuing such firms. Examples of such firms include utility companies such as phone and power

companies. In addition, in sectors where cash flow estimation is difficult, dividends are the only cash flows that

can be determined with a degree of precision. The DDM is apt for valuing financial services firms for tworeasons. First, calculating free cash flows for a bank, insurance or financial services firm is very tough as it is

really hard to estimate working capital and capital expenditures for these firms. The second reason is that

retained earnings and book equity have real consequences for financial services companies since their

regulatory capital ratios are computed based on book value of equity.

There are many variations to the DDM developed over time. The simplest extension of infinite DDM is a two-

stage growth model where there is an initial phase with a growth rate that is not stable, followed by a

subsequent steady state where growth is stable and expected to remain so for the long term.

Based on Infinite growth Dividend Discount Model,

Value of stock = Expected dividends next period / (Cost of equityExpected growth rate in perpetuity).

Using the above method to value RIL, assuming a stable growth rate of 10% (which is the growth rate for the

past 2 years, i.e. 2009 and 2010), we get-

Dividend Discount Model 2010-11 (E)

Value as on 31 Mar 2010

Assuming stable growth = 10%

Price of Stock (Present Value) Rs. 1,010.52No of Shares Outstanding(in Cr) 327.03

Market Value of Equity (in Cr) Rs. 3,30,470.82

Market Value of Debt (in Cr) Rs. 62,494.69

Value of Firm (in Cr) Rs. 3,92,965.51

FREE CASH FLOW TO EQUITY

Another measure is free cash flow to equity which is a measure of cash flows similar to the operating free cash

flow, but after payments to debt holders, which means that these are cash flows available to equity holders,

therefore the appropriate discount rate is the firms cost of equity.

When we use the FCFE model to value a firm, we are implicitly assuming that the FCFE will be paid out to

stockholders. Hence, we assume that there will be no cash build up in the firm, since cash available after debt

payments and reinvestment needs is paid out to stockholders. In addition, the expected growth in FCFE is due

to growth in income from operating assets and not growth in income from increases in marketable securities.

The FCFE model is apt for valuing firms whose dividends are significantly higher or lower than the FCFE. It gives

a realistic value of high-growth firms that might be expected to have negative FCFEs in the near future.The

discounted value of these negative cash flows captures the effect of the new shares that will be issued to fund

the growth during the period, and thus captures the dilution effect of value of equity per share today.


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The FCFE model is quite similar to the DDM model, and often gives a higher value of the firm than that

calculated under the DDM model. The question as to which models value is more appropriate is answered by

the openness of the market for corporate control. If there is a high probability that the firm can be taken over

and its management changed, the market price will reflect that likelihood and the value from FCFE model is

more appropriate. As changes in corporate control become more difficult, either due to the firms size, or

legal/takeover restrictions, the value from DDM is more appropriate.

The assumptions and inputs required both for FCFE and FCFF method valuation of RIL are as follows:

Beta 1.13 (based on 3 Year QoQ returns)

Risk Free Rate 7.27% (1 yr T-Bill Yield)

Sensex Return 10.30% (1 yr Monthly HPY)

Cost of Debt 3.40% (Average Yearly EffectiveInterest Rate)

1 - Tax Rate 82.96% (Average Yearly Effective TaxBurden)

After Tax Cost of Debt 2.82%

Cost of Equity (CAPM) 10.69%

Stable Growth Rate (after Supernormal Growth) 6.50%

The value of RIL using the FCFE method and multistage growth assumption is calculated as follows. Here FCFE

is calculated as

FCFE = Net income + Depreciation Capital expenditures Change in non-cash working capital (New debt

issued Debt repayments)

2009-2010 2010-11 (E) 2011-12 (E) 2012-13 (E)

Free Cash Flow to Equity 1496.52 6968.44 16866.54

Terminal Value of Equity at 2013 428309.4223Present Value Factor 0.90 0.82 0.74

Present Value 1351.94 5687.06 328216.68

Market Value of Equity (in Cr) Rs. 4,53,640.92

Market Value of Debt (in Cr) Rs. 62,494.69Value of Firm Rs. 5,16,135.61

FREE CASH FLOW TO FIRM

The third type of cash flow is the operating free cash flow, which is described as cash flows after direct costs

and after allowing for cash flows to support working capital expenditure and capital expenditures required for

future. The discount rate used in this case is the weighted average cost of capital because it deals with cash

flows for all capital suppliers to the firm. It is useful to value firms with diverse capital structures because the

value of the total firm is determined and then the firms debt is subtracted to get the value of the firms

equity. It is the cash flow after taxes and reinvestment needs, but before any debt payments.

The primary difference between equity and debt holders in these firm valuation models lies in the nature of

their cash flow claims lenders get prior claims to fixed cash flows and equity investors get residual claims to

remaining cash flows.

The Valuation of RIL using the FCFF method is done as follows, where FCFF is calculated as


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Free cash flow to firm = After-tax operating income (Capital expenditures Depreciation) Change in non-

cash working capital

2009-2010 2010-11 (E) 2011-12 (E) 2012-13 (E)

Free Cash Flow to Firm 8101.03 12961.82 19539.24

Debt to Equity Ratio 0.45 0.43 0.39

Weight of Debt 31.16% 30.31% 28.23%

Weight of Equity 68.84% 69.69% 71.77%WACC 8.24% 8.31% 8.47%

Present Value Factor 0.92 0.85 0.78

Terminal Value of Firm at 2013 1055484.32

Present Value 7484.30 11049.65 842307.31

Value of Firm Rs. 8,60,841.26

RELATIVE VALUATION TECHNIQUES

The relative valuation techniques provide information about how the market is currently valuing stock at

several levels, that is, the aggregate market, alternative industries and individual stocks within the industries.

One disadvantage of relative valuation is that it does not to provide guidance on whether these current

valuations are appropriate, that is, valuations at a point in time could be too low or too high.

The relative valuation techniques are appropriate to consider under two conditions:

1. There is a good set of comparable entities i.e., comparable companies that are similar in term of industry,

size and risk.

2. The aggregate market and the companys industry are not at a valuation extreme, that is, they are not

seriously undervalued or overvalued.

In this discussion the following relative valuation ratios will be covered: - a) price/earnings (P/E), b) price/cash

flow (P/CF), c) price/book value (P/BV) and d)price/sales (P/S)

PRICE TO EARNINGS RATIO

Earning power is the chief driver of investment value, and EPS is perhaps the chief focus of any security

analysts attention. P/E is widely recognized and used by investors. Both Financial analysts as well as

professional investors rank the simple P/E ratio method as the most important valuation model. However, in

some cases, the EPS might be negative and P/E may not make economic sense. Also, earnings often have

volatile components, making the analysts task difficult. They also vary with accounting practices.

The two chief definitions of P/E are trailing P/E and leading P/E. a stocks trailing P/E is its current market pricedivided by its most recent 4-quarters EPS. In such calculations, EPS is referred to as trailing 12 months EPS.

The leading P/E is defined as the stocks current market price divided by the next years expected earnings.

Different industries and sectors may have different ranges of P/E ratios that are considered to be normal for

that particular industry. One way to find out if a particular sector is over(under)priced is when the average P/E

ratio of all the companies in the industry is far above(below) the historical average. The P/E ratios of some


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types of companies (e.g. software manufacturers) are all generally higher than P/E ratios for companies in

other industries (e.g. auto manufacturers)

The P/E for a stock is a function of both the level and quality of its growth and risk.

PRICE TO BOOK VALUE RATIO

Book value per share (BVPS) attempts to represent the investment the companys shareholders have made in

the company on a per-share basis. As a measure of net asset value per share, BVPS has been viewed as

appropriate for valuing companies composed chiefly of liquid assets such as finance, investment, insurance

and banking institutions. For such companies, book value of assets may approximate market values. Book

value has also been used for valuation of companies that are not expected to continue as a going concern.

Because BVPS is more stable than EPS, P/BV may be more meaningful than P/E when EPS is abnormally high or

low, or is highly variable. Book value is also generally positive.

Some drawbacks of P/BV are it does not recognize intangible assets and human capital, difference of average

age of assets among companies being compared and inflation effects.

It is calculated as Shareholders equity minus total value of equity claims that are senior to common stock on a

per-share basis.

A P/BV ratio of greater than one indicates that the stocks are priced at greater than their historical book values

in the market. In times when the economy is in a boom phase, historically, companies have traded above the

P/BV ratio of two indicating the upside/potential that stocks below their current book value would carry.

However, P/BV varies quite a bit with respect to the industry. Companies that require more infrastructure and

physical capital usually trade at much lower P/BVs than companies which say, require more human capital,

say consulting firms. A higher P/BV usually indicates that the investors expect the management to generate

more value from a given set of assets. It also gives some idea of whether an investor is paying too much for

what he would get in case the company went bankrupt.

PRICE TO SALES RATIO

Certain types of privately held companies, including investment management companies and companies in

partnership form have long been valued as a multiple of annual revenues, thus the ratio of price to sales has

become well known as a valuation multiple for public traded companies.

Sales are generally less subject to distortions and manipulations as compared to other fundamentals such as

EPS or book value. Sales are positive even when EPS is negative. Also, because sales are generally more stable

than EPS, which reflects operating and financial leverage, P/S is generally more stable than P/E.

Some drawbacks of P/S are it does not always reflect profitability, cost structure and might be subject to

manipulation via revenue recognition practices.

It is calculated as Price per Share divided by annual net sales per share.

The P/S ratio is appropriate for valuing companies or industries which are cyclical in nature and are vulnerable

to the business cycle such as the construction and automotive industries. Based on the economic conditions,


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these firms will have large shift in their earnings power, making their earnings figures less reliable. During

these periods, the stocks may become depressed in value and the price to sales ratio can help investors find

bargains within the sector. Some analysts claim that it is best suited for large cap companies as they can keep

up the large sales they generate. It also is difficult to use it for the services companies, because they dont

make any sales, just provide different types of services.

PRICE TO CASH FLOW RATIO

Price to cash flow is a widely used valuation indicator. Cash flows are usually less subject to manipulation than

earnings. They are generally more stable than earnings. Using P/CF rather than P/E addresses the issues of

accounting conservatism between companies.

When the EPS plus noncash charges approximation to cash flow from operations is used, items affecting actual

CFO such as non cash revenues and net changes in working capital are ignored.

Free cash flow rather than cash flow is viewed as the appropriate variable for valuation. We can use the price

to free cash flow to equity, but it has a possible drawback of being more volatile compared to Cash flow , formany businesses. FCFE is also more frequently negative than cash flows.

Price-to-cash-flow ratios vary widely from industry to industry, with capital-intensive industries such as auto

manufacturing or cable TV tending to have very low multiples, and less infrastructure-heavy industries, like

software, having higher P/CF ratios. The P/CF ratio is generally used to value companies in the hard asset

business such as gold, oil and real estate companies.

In the following tables the valuation of RIL is done using the various multiples. The multiples are assumed to

remain constant in the forecasted years, and the expected stock price in the forecasted years is calculated by

taking a geometric mean of the stock price forecasted by each of the relative valuation methods.

2009-10 2010-11 (E) 2011-12 (E) 2012-13 (E)

Market Price as on 31-03 1010.40 1551.5997 1981.1232 2527.8951EPS 49.65 82.99 107.97 140.08

BVPS 419.44 479.68 558.49 661.45

Sales Per Share 608.11 754.26 935.53 1160.37

Cash Flow Per Share (EBITDA perShare)

24.63 57.75 81.70 113.64

Relative Valuation Ratios as on 31-3-2010

Market Price Assuming constantvaluation ratios

P/E 20.35 1689.1091 2197.5188 2850.8904P/BV 2.41 1155.5125 1345.3387 1593.3803

P/S 1.66 1253.2353 1554.4326 1928.0184P/CF 41.03 2369.4841 3352.0447 4662.5666


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DISCOUNTED CASH FLOW V/S RELATIVE VALUA TION METHODS

The two approaches to valuation will almost always yield different values for the same asset/firm at the same

point in time. It might be possible that one approach states that the stock is undervalued whereas the other

says its overvalued. Even using different methods within these approaches, we can arrive at different values

for the same firm. The differences in value between discounted cash flow valuation and relative valuation

come from different views of market efficiency. In discounted cash flow valuation, we assume that markets

make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across

entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes

on individual stocks, they are correct on average.

No one method is correct or superior to the other. It is the accuracy and consistency of the estimates of the

inputs required for these methods that will give a more accurate or superior value.

APPLICABILITY OF METHODS WITH RESPECT TO SCENARIO

y Start-ups- Startups are driven by far too many factors to be captured by simplistic valuation models.

Their sensitivity to Economic, Sector Specific and Company specific factors must be captured as far as

possible to reasonably value them. These factors can only be captured with the DCF method.

y Matured Companies, have fairly predictable financials and hence DCF will result in a fairly reliable

valuation. However, the Dividend Discount Model will also work reliably, as matured companies have

nominal expansion needs and hence a high dividend payout ratio along with predictability of growth

rates. E.g. Large FMCG companies

y IPOs - Although, for such situations it is best to use DCF as it determines the intrinsic value, not many

will want to use it as it is likely to understate value as against Comparable valuation. Simply because,

the idea behind an IPO is to raise maximum possible capital for a minimum dilution in equity. Hence

most IPOs come out in bull markets where valuations are al ready high and Comparable Valuation will

result in higher values as compared to DCF, as a result of circularity involved in such the approach.

Consequently, IPOs are demand driven rather than intrinsic value led, as a result many average

companies get extraordinary valuations.y High growth companies have drastically changing market shares and hence it is very difficult to

compare them with a benchmark, making comparable valuation difficult and leaving one to go with

the DCF approach. E.g. Telecom companies

y Cyclical Companies, by virtue, have a very high degree of uncertainty. Secondly, such companies are

always on the radar for news & management comment both of which are immediately reflected in

Comparables. On the other hand, DCF may have to wait for a quarter or more to reflect a change. E.g.

Sugar Companies

y Distressed company valuation, is particularly tricky as the challenge lies in finding fair value and not

the lowest value. By distressed, it means loss making companies or those that are restructuring their

businesses by selling off toxic assetsand toning down capital structure. Traditional valuation

approaches fail miserably as a result of the uncertainty involved and this is where Liquidation Value &

Replacement cost method come in to play. Liquidation Value measures return from selling off or

liquidating the assets while Replacement Cost measures the opportunity cost of setting up a business.

E.g. Many Textile Companies


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REFERENCES

1. L. Corteau et al.(2006), Relative accuracy and predictive ability of direct valuation methods, price to

aggregate earnings method and a hybrid approach,Accounting and Finance 46 (2006), pp 553- 575.

2. Bertoncel (2006), Acquisition valuation: how to value a going concern?, NG, T. (2006)

Razprave/Discussions.

3. Chandra and Ro (2008), The Role of Revenue in Firm Valuation, Accounting Horizons, AmericanAccounting Association, Vol. 22, No. 2, pp 199222.

4. Relative Company-Valuation Methods And Lessons Of The Global Financial Crisis, Dimiter N. Nenkov(2010)

5. India-Infoline (2010), Sector Preview, Oil and Gas Q4 FY10, April 8.

6. JPMorgan (2010), Equity Research Report, Reliance Industries Limited, July 28.

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Accounting and Finance46 (2006)x xxxxx

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Different Approaches to Valuation