CHAPTER 10

VALUATION PRINCIPLES

Learning objectives

• Need for business valuations and sources of value in a

business
• Various approaches to valuation
• Different types of business valuation models
• Objectivity of valuations and important considerations in
business valuation

10.1 WHAT IS THE DIFFERENCE BETWEEN PRICE & VALUE

Price is the market-set cost of an asset, influenced by market dynamics and emotions.

Value, on the other hand, is the intrinsic worth determined by fundamental factors

Valuation of an asset is a nuanced process due to the lack of a precise formula. The
uncertainties in input factors may lead to subjective values

10.2 WHY VALUATION IS REQUIRED

• Buying or selling a business for investment purposes.

• Facilitating mergers and acquisitions.
• Establishing a general sense of a business's value for owners.
• Ensuring fair treatment of stakeholders in equity swap situations.

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 10.3 SOURCES OF VALUE IN BUSINESS

• Warren Buffet identifies earnings and assets as the sole contributors to a business's
value.

• Financial and real assets generate cash flows through periodic earnings and final
inflows upon sale.

• Bonds produce earnings via coupons and generate one-time cash flows upon redemption
or sale.

• Equities yield earnings in the form of dividends and offer one-time cash flows upon
sale.

• Real estate provides rental income and appreciates in capital value upon sale.

10.4 APPROACHES TO VALUATION

COST BASED VALUATION

Imagine you have the option to either buy a ready-made item or build it from scratch.
Cost based valuation gives you that amount.
Not the go-to choice for regular stock investors who don't want to run the business.
It's more for one planning to stick around for the long run

CASHFLOW BASED VALUATION

' This method assesses an asset's value by examining the cash it produces. Investors
estimate its worth by discounting the future cash flows at a rate reflecting the
expected return

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 Risk Neutral Valuation:
Adjusting cash flows at a risk-free rate, commonly used in valuing insurance companies.

Real World Valuation:

Discounting cash flow at risk-free rate plus a suitable risk premium to address cash flow
uncertainties.

SELLING PRICE BASED VALUATION (RELATIVE VALUATION)

Valuing an asset based on the prices of similar assets, utilising metrics like P/E, P/B,
EV/EBITDA.

10.5 DISCOUN TED CASH FLOW MODEL FOR BUSINESS VALUATION

The underlying principle is the time value of money, recognising that a rupee today is worth
more than the same rupee in the future due to factors like inflation and opportunity cost.

- Cash Flows (CF):

Future cash inflows and outflows generated by the investment.

- Discount Rate (r):

Represents the cost of capital or required rate of return.

- Terminal Value (TV):

An estimate of the investment's value at the end of the projected period.

The DCF formula is a sum of the present values of all projected cash flows and the terminal
value discounted to the present.

DCF = CF₁ / (1 + r)¹ + CF₂ / (1 + r)² + ... + CFₙ / (1 + r)ⁿ + TV / (1 + r)ⁿ

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Example:

STEPS

• Estimate the future cash flows the investment is expected to generate.

• Determine an appropriate discount rate, often the cost of capital or a required rate of
return.

• Calculate Present Value:

Discount each future cash flow and the terminal value to its present value using the
chosen discount rate.

• Sum Up:
Add up all the present values to obtain the DCF value.

Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate
approach for valuations when three things are known with certainty:

• Stream of future cash flows

• Timings of these cash flows, and
• Expected rate of return by the investors (called discount rate).

There are three different approaches to DCF models :

DIVIDEND DISCOUNT MODEL

• DDM values a company by calculating the present value of its future dividends,
discounted at the cost of capital.

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 • Best suited for mature companies in stable industries that consistently pay significant
dividends.

• Unlike bonds, stocks have indefinite life, and dividends aren't contractually guaranteed.

• Requires estimates and assumptions due to the non-contractual nature of dividends.

• Gordon Growth Model:

Gordon Growth Model (Perpetual Growth Model) Formula:

- Evaluates the value of a dividend-paying company with perpetual, constant growth in

dividends.

or

- Calculates the fair value of company shares based on its expected future dividends,
accounting for perpetual growth.
- Formula:
P =D1/k−g

- P : Fair value of shares.

- D1 : Expected dividend at the end of the year.
- k : Cost of equity.
- g : Constant growth rate of dividends.

Example Calculation:

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 Parth Verma The Valuation School

FREE CASH FLOW TO EQUITY:

FCFE is introduced to address limitations of DDM, allowing valuation for companies not
paying dividends.

• FCFE models suit high-growth phase companies, yet assuming a constant growth rate
may be inaccurate if it's exceptionally high and unsustainable.

• For companies experiencing extraordinary growth, a two-stage valuation is suggested.

This involves evaluating the present value of FCFE during the high-growth phase and
the perpetual FCFE stream post this period, termed as the terminal value.

• Executing a two-stage valuation requires

determining the high-growth phase's duration,
estimating FCFE for each period, and applying the
Gordon growth model. It's crucial to note that the
terminal value requires additional discounting to
its present value.

FREE CASH FLOW TO FIRM

FCFF model is introduced due to challenges in estimating net borrowings in FCFE models,
especially for companies without clear debt policies.

FORMULA:
*EBIT*×(1-Tax rate)
+Depreciation−Increase (Decrease) in working capital−Capital Expenditure+Non-cash charges.

CALCULATION:

• similar to FCFE model in FCFF model, Future cash flow to Firmare discounted at rate-
weighted average cost of capital

• WACC is used for FCFF valuation, reflecting both debt and equity costs. Cost of equity is
calculated using CAPM.

• Terminal value often uses the perpetual growth model or considers the expected sale value
of the business.
10.6 RELATIVE VALUATION

• Relative valuation is a method to assess a business's value by comparing its price to

relevant financial metrics like earnings and assets.

• Relative valuation aims to gauge if a business is priced attractively or expensively in

comparison to its peers or industry benchmarks.

• Analysts use this approach to make buy, sell, or hold recommendations by evaluating what
investors pay (price) against what they receive in terms of earnings and assets.

10.7.1 PRICE TO DIVIDEND YEILD

Dividend Yield is a measure comparing a company's annual dividends to its current stock
price.

Formula → Dividend Yield = Div Per Share / Current Stock Price

• Investors evaluate a stock's Dividend Yield against the broader market or industry to
assess its competitiveness.

• Income-focused investors, a higher Dividend Yield indicates a better potential for

generating income OR means stock price is lucrative.

• Low Dividend Yield might signal risk that stock is trading at high prices

10.7.2 PRICE TO EARNING RATIO (P/E)

• P/E Ratio, or Price-to-Earnings Ratio, is calculated by dividing the current stock price
by the Earnings Per Share (EPS).

• It signifies the amount an investor invests to gain 1 unit of profit and can be based
on historical or forward-looking EPS.

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• A higher P/E compared to peers and the market suggests an expensive stock, while a
lower P/E may indicate an undervalued stock.

• Companies with high growth potential may have a premium P/E, and vice versa. Analysts
should factor in future earnings estimates and assess the appropriate period of
reference for EPS

10.7.3 PEG RATIO

• PEG Ratio helps investors assess if a stock is overvalued, undervalued, or priced just
right by factoring in the expected growth in earnings.

• Growth adjusted Price to Earnings Ratio = [Current Price of Stock / Earnings Per
Share] / Growth rate.

• A PEG ratio less than 1 suggests that the stock might be undervalued, while a ratio
greater than 1 could indicate overvaluation.

• If two companies have the same P/E ratio but different growth outlooks, the PEG ratio
provides a more nuanced view. For instance, if Company A has a P/E of 12 and is
expected to grow at 10%, its PEG ratio is 12/10=1.2. Meanwhile, Company B with a P/E
of 12 and a growth rate of 15% has a PEG ratio of 12/15=0.8. In this scenario, Company
B appears more attractively priced when considering growth.

• The concept was introduced by investor Peter Lynch, emphasizing the need for caution
as high growth may not be sustained indefinitely.

10.7.4 EV/EBI TDA

• EV/EBITDA is suitable when assessing a company from the viewpoint of an acquirer

or as a potential acquisition target.

• Both EV/EBIT and EV/EBITDA are neutral to a company's capital structure,

providing a fair comparison.

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• In capital-intensive industries, EV/EBITDA is preferable due to potential discrepancies
arising from historical asset costs and depreciation methods.

• Since it accounts for the entire capital structure, EV/EBITDA is less impacted by
variations in the company's debt and equity mix.

10.7.5 EV/SALES

• In situations of negative or extremely low profits, traditional multiples like PE or EV/

EBITDA may yield disproportionately high values, making them less meaningful.

• EV/Sales provides a more meaningful metric in cases of loss-making companies,

considering sales can never be negative.

• Appropriate for companies expected to turn profitable and sustain profitability in the
future. Not recommended for companies with no foreseeable turnaround.

• Suitable for companies recently breaking even where traditional profit metrics may be
significantly lower than long-term potential.

ASSET BASED VALUATION METRIC

While the previous section focused on comparing what's paid and received in terms of earnings,
this section shifts the focus to assets on the balance sheet.

Unlike earnings-based valuation that considers the future cash flows a business generates,
asset-based valuation looks at the inherent value of the assets themselves.

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 10.8.1 PRICE / BOOK VALUE

• Indicates how much an investor needs to invest to gain ownership interest in a

company.

• Calculated as Market Capitalization divided by Balance Sheet Value of Equity or Price

per Share divided by Book Value per Share.

• Preferred for valuing financial sector companies due to the reliability of book value
numbers, especially when monetary assets dominate.

• In capital-intensive and technology sectors, historical cost accounting and intangible

assets may limit the effectiveness of this ratio.

• Lower Price/Book (P/B) ratios generally indicate more attractive valuations, but
companies with higher Return on Equity (ROE) might command a premium.

• Preferably compared against industry averages for a more contextual assessment of a

company's valuation.

10.8.2 EV / CAPITAL EMPLOYED

• EV = Value of Equity + Value of Debt – cash and cash equivalents

EV to Capital Employed ratio is defined as:

EV to Capital Employed ratio = Enterprise Value

Capital Employed (Total Equity + Total Debt)

• This ratio provides insight into how the market values the company relative to the
total capital invested.

• Investors use this ratio, along with ROCE, to assess whether the return on invested
capital meets their expectations.

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 Parth Verma The Valuation School

10.8.3 NET ASSET VALUE APPROACH

• NAV of equity is the market value of an entity's assets minus its liabilities.

• Unlike book value, NAV uses market values, not book values, for assets.

• It can represent the total equity's current value or be divided by outstanding shares
for NAV per share.

• Common in asset-intensive industries like Real Estate, Shipping, and Aviation.

OTHER METRIC

• Analysts choose ratios based on industry dynamics and specific business situations.

• Incorporates non-financial metrics for a more comprehensive understanding.

• Offers targeted insights in scenarios where traditional financial metrics may not be
reflective.

• Life Insurance Sector:

Price/EV for assessing life insurers' embedded value.

Compares market price to the embedded value, representing the present value of expected net
future cash flows from current policies.

• NBFC Valuation:
Price/ABV considered for a more comprehensive evaluation.

Compares market price to the adjusted book value, considering fair values of assets and
liabilities, including off-balance-sheet items.

• Operational Assessment:
EV/Capacity used when traditional financial metrics may not capture a company's
potential value accurately.

Appropriate for start-ups or companies undergoing special situations.

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10.9 RELATI VE VALUATION TRADING & TRANSACTION MULTIPLES

• An intuitive approach comparing an asset's value to similar assets in the market, akin
to how we assess real estate prices based on comparable properties.

• Reflects the current market sentiment,hence emphasises the importance of using

parameters like maximum, minimum, and average for a balanced assessment.

• Comparables can be derived from stock market data (Trading Multiples) or similar
transactions (Transaction Multiples), providing different perspectives on valuation.

10.10 SUM OF THR PARTS VALUATION

• SOTP Valuation is applied to conglomerates with diverse business verticals, such as ITC
or L&T, where each business is treated as a separate entity for valuation.

• Each business under the conglomerate is valued independently, considering earnings and
assets as in traditional valuation methods, allowing for a more nuanced and accurate
valuation.

• The values of individual businesses are then summed up, providing an aggregate
valuation for the entire conglomerate.

10.11 NEW AGE BUSINESS VALUATION

• Valuing new-age businesses like E-commerce or tech firms (WhatsApp, Zomato,

Facebook) poses challenges due to unconventional metrics and evolving market dynamics.

• New-age economy introduces unconventional metrics like, page reviews, footfall, ARPU
(Average Revenue Per User), and user base, creating a unique language for valuation.

• Despite the unconventional metrics, the ultimate expectation remains profitability.

Warren Buffett's principle emphasizes that these businesses should translate metrics
into profits over time.
10.12 OBJECTIVES OF VALUATION

• Despite intricate quantitative models, valuation lacks precision. The complexity of models
may create a false impression of accuracy, but it doesn't guarantee a precise estimate of
value.

• Valuation is not static; it dynamically responds to shifts in business circumstances.

Dramatic changes in the business environment can lead to significant alterations in
valuation.

10.13 SOME IMPORTANT CONSIDERATIONS IN THE CONTEXT OF BUSINE

SS VALUATION

• If earning power of a business is high, book value (BV) of shares could be less important.
But, if earning power of business is low, BV becomes very important.

• As equity/share reflects part ownership in a business, to value share, we need to value

entire business.

• EV and not the market capitalization is the true value of the firm for private owner.

• PE for a leveraged firm may be deceptive – look at debt levels in the business.

• Look at the consolidate numbers and not just the standalone numbers.

• Focus on ROE and not EPS – EPS does not account for retained earnings.

• Leverage improves ROE but excessive leverage is risky.

• Differentiate between ROCE and ROE – ROCE reflects the true return on capital. ROE
could be manipulated by high leverage.

• ROCE and ROE should be closely knit. Any wide variation should trigger investigations.

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