valuation
TRANSCRIPT
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ValuationValuation
Date: 9 July 2006Prepared: Best Practices Team
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OVERVIEW OF SHAREHOLDER VALUE OVERVIEW OF SHAREHOLDER VALUE CREATIONCREATION
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InvestmentDecisions
OperatingDecisions
FinancingDecisions
Working capital; facilities;Programs
Price, volumeand cost trade-offs;Cost effectiveness
Debt, equityleveragepayout
Life, cycles;competition
Net Cash Flow from Operations
Discount rate
Cost of Capital Capital markets
Shareholdervalue
Dividends Capital gains
The manager The investor
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What is Value?What is Value?
Value as a term has many meanings and is used to indicate actual, appraised, book, break-up, carrying, real, reproductive, depreciated, fair, face, fair market, going concern, insurable, intangible, intrinsic, liquidating, market, residual, sound and true value.
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Our View of ValueOur View of Value
In the context of a firm, value commonly refers to either the value of the assets (book, market, or liquidation) or the value of an income stream (dividends, earnings, cash flow). The value of a income stream (cash flows) is a rationally determined and economic estimate of future earning potential of the firm.
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Why value value?Why value value?
DCF is the best metric for corporate performanceShareholders maximize their own claims, simultaneously maximize everyone else’s claims.Corporate failure; capital flows away
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Shortcomings of Accounting NumbersShortcomings of Accounting Numbers
EarningsAlternative methods of accounting may be employedInvestment requirements are excludedTime value of money is ignored
ROIROE
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Impact of Accounting PoliciesImpact of Accounting Policies
Assumed no tax, no interest
Policy A Policy B Years 1 2 1 2
PBDIT 400 600 400 600 Depn. 200 200 400 100 PBIT 200 400 0 500 Cash flow 400 600 400 600
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Impact of Time Value of MoneyImpact of Time Value of Money
Case 1Sales 200Optg. Exp. 170PBIT 30Tax 12PAT 18Value = 18/0.12 = 150
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Impact of Time Value of MoneyImpact of Time Value of Money
Case 2Sales 220Optg. Exp. 187PBIT 33Tax 13.20PAT 19.8Value = 19.8/0.12 = 165 - 15 (Inv) = 150Earning Up; Value constant
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Impact of Time Value of MoneyImpact of Time Value of Money
Case 3Sales 240Optg. Exp. 206PBIT 34Tax 13.60PAT 20.4Value = 20.4/0.12 = 170 - 30 (Inv) = 140Earning Up; Value Down
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Approaches to ValuationApproaches to Valuation
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Models of ValuationModels of Valuation
F irm
D ivid en d sF C F to E q u ity
E q u ity
C la im h o ld er
S tead y S ta teTwo S tag eTh ree S tag e
G rowth P a tte rn
D C F M od e ls
F u n d am en ta lC om p arab le F irm sR eg res s ion
A p p roac h
P /E R a tiosP /B V R a tioP /S a les R atio
M u lt ip les
R e la t ive V a lu ation M od e ls
E q u ityN a tu ra l R es ou rc eP rod u c t
O p tion P ric in g M od e ls
V a lu a tion M od e ls
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Some statements people make Some statements people make about Valuationabout Valuation
True or False? Why?Valuation is objectiveA well researched and well-done valuation is timelessA good valuation provides a precise estimate of valueThe more quantitative the model, the better is the valuation
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Some statements people make about Some statements people make about Valuation (contd…)Valuation (contd…)
The market is generally wrongThe product of valuation -- value -- is what matters; the process of valuation is not important
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DISCOUNTED CASH FLOW APPROACHDISCOUNTED CASH FLOW APPROACH
Explicit forecast period Continuing value period
nnn
kCV
kCF
kCF
kCF
)1()1()1()1(Value 2
21
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STEPS IN A DCF VALUATIONSTEPS IN A DCF VALUATION
Forecasting free cash flowEstimating the cost of capitalEstimate the continuing valueCalculating and interpreting results
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Free cash flowFree cash flow
Total after tax cash flow generated by the company that is available to all providers of capitalFree cash flow is generally not affected by the company’s capital structure
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Free Cash Flow CalculationsFree Cash Flow Calculations
EBITLess Tax on EBIT
Gives Net Operating Profit less adjusted taxes (NOPLAT)
Add DepreciationGives Gross Cash Flow
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Free Cash Flow CalculationsFree Cash Flow Calculations
Estimated Gross investmentCapital ExpendituresInvestment in working capitalincrease in other assetsInvestment in goodwill
Gross cash flow less Gross investmentGives free cash flow to the firm
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Free cash flow from other sideFree cash flow from other side
Change in excess marketable securitiesLess: after tax-interest incomeAdd: decrease in debtAdd: after tax interest expenseAdd: dividends
Gives Total financial flow
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Thumb ruleThumb rule
Free cash flow = Total financial flowContinuing value forecast
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Cash Flow EstimationCash Flow Estimation
2003 2004
EBIT 1430 1480
Add: Goodwill Amortization
20 20
Adjusted EBIT 1450 1500
* Provision for tax 495 4276
- Tax shield on interest income
7 7
+ Tax shield on interest expense
213 181
+ Change in Deferred tax
20 100
Tax on EBIT 681 500
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Cash Flow EstimationCash Flow Estimation
2003 2004
+ Depreciation 387 400
Gross Cash Flow 1156 1400
+/- Change in NWC -123 -150
- Capex 587 600
-Change in Investment in OA
30 50
Total Capex +NWC -740 -800
Net Cash Flow 416 600
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STEPS IN A DCF VALUATIONSTEPS IN A DCF VALUATION
Forecasting free cash flowIdentify components of free cash flowDevelop integrated historical perspectiveDetermine forecast assumptions and scenariosCalculate and evaluate the forecast
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Developing integrated historical perspectiveDeveloping integrated historical perspective
Analysing historical free cash flow statements, supported by Income Statements and Balance Sheets of previous 5 to 10 yearsAnalysing the rate of return on invested capital over historical periodAnalysing the historical investment rate and its implications
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cont.cont.
Drawing a conclusion about the sustainability of the company’s rate of return in excess of WACC
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Determine forecast assumptions and Determine forecast assumptions and ScenariosScenarios
Determine the overall structure of the forecastDevelop relevant scenariosDeveloping a point of view about a forecast for each variableDeciding on the length of forecast
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A StoryA Story
Demand is increasingly rapidly because of changing demographics, yet prices will remain stable because of the competitive structure of the industry. Given the company’s competitive position, it should be able to increase its market share somewhat, although profitability will remain constant.
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ForecastForecast
Build the revenue forecast. This should be based on volume growth and price changes.Forecast operational items such as operating costs, working capital, PP&E by linking them to revenues or volumes.Project non-operating itemsProject the equity accounts. Equity should be equal to last year’s equity plus net income and new share issues less dividends and share repurchases.
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ForecastForecast
Use the cash and/or debt accounts to balance the cash flows and balance sheetCalculate the ROIC tree and key ratios to pull elements together and check for consistency
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Consistency and AlignmentConsistency and Alignment
Is the company’s performance on the value drivers consistent the company’s economics and industry competitive dynamics?Is the revenue growth consistent with the industry growth? If the company’s revenue is growing faster than the industry’s, which competitors are losing share. Will they retaliate? Does the company have the resources to mange the rate of growth?
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Consistency and AlignmentConsistency and Alignment
Is the return on invested capital consistent with the industry’s competitive structure? If the entry barriers are coming down, shouldn’t expected returns decline? If the customers are becoming more powerful, will margins decline? Conversely, if the company’s position in the industry is becoming much stronger,should you expect returns to increase? How will the returns look relative to competition?
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Consistency and AlignmentConsistency and Alignment
How will technology affect the returns? Will they affect risk?Can the company manage all the investments it is undertaking?
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STEPS IN A DCF VALUATION …contdSTEPS IN A DCF VALUATION …contd
Estimating the cost of capitalDevelop target market value weightsEstimate the cost of equityEstimate the cost of non equity finance
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COST OF CAPITALCOST OF CAPITAL
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WACCWACC
k = ke * we + kd * (1-t) * wd
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Target WeightsTarget Weights
Why target weights rather than year-to-year weights?
“Lumpiness” of financingSolves problem of circularity
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Target Weights--How do I take care of:Target Weights--How do I take care of:
Debt financingStraight debtVariable rate debtLeasesOption featuresSwapsForeign currency obligations
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Target Weights--How do I take care of:Target Weights--How do I take care of:
Equity linked/hybrid Warrants and ESOsConvertible securities
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Target Weights--How do I take care of:Target Weights--How do I take care of:
Equity
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Target Weights--How do I take care of:Target Weights--How do I take care of:
Preferred
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Cost of EquityCost of Equity
Gordon’s (Dividend Discount) ModelCapital Asset Pricing Model
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Gordon’s ModelGordon’s Model
kDP
ge 1
0
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Value of Stcok and Expected Growth
0
50
100
150
200
250
300
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Expected Growth Rate
Stoc
k Va
lue
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Measuring GrowthMeasuring Growth
Analysts’ ForecastHistorical Time Series ApproachSustainable Growth Model
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Analysts Forecast Analysts Forecast
Specialised services like ValueLine provide growth estimatesOwn estimates
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Historical Time Series ApproachHistorical Time Series Approach
Arithmetic or geometric growth ratesRegression
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Negative earningsNegative earnings
Percentage change in EPS = (EPSt-EPSt-1)/Max(EPSt, EPSt-1)
Or(EPSt-EPSt-1)/| EPSt-1|
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Sustainable Growth ModelSustainable Growth Model
g = (plowback ratio) * (return on equity)
or
g = (plowback ratio) * (ROA + D/E*(ROA-i(1-t)))
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Sustainable Growth ModelSustainable Growth Model
g = (plowback ratio) * (ROA + D/E*(ROA-i(1-t)))
This implies that:ROE = (ROA + D/E*(ROA-i(1-t)))How?
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Sustainable Growth ModelSustainable Growth Model
Let’s define:ROA = [Net Income (NI) + Interest(I)*(1-t)]/
BV of assetsD/E = BV of debt/BV of assetsi = Interest expense on debt/BV of debtT= tax rate on ordinary income
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Sustainable Growth ModelSustainable Growth Model
Now, by substitution:ROA + D/E*(ROA-i*(1-t)) =[NI+I*(1-t)]/ (D+E) + D/E *{[NI+I*(1-t)]/ (D+E) –
I(1-t)/D }On simplification this term equalsNI/E or ROE
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Value of past growthValue of past growth
Variability
Size of firmCyclicality in economy
1
)(1
n
ggn
tt
t
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Value of past growthValue of past growth
Change in fundamentalsBusiness mix, Project choice, Capital structure, dividend policy, market forces, government regulations
Quality of earnings
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Information used by analysts in making Information used by analysts in making forecastsforecasts
Firm specific public informationMacroeconomic factorsInformation revealed by competitors regarding future projectsPrivate information about firmsPublic information other than earnings
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Individual Product line forecastIndividual Product line forecast
)])1([( tiEDbg jtjtjtjtjt
j linepdt for year t in rategrowth jtgj linepdt for year t in margin profit jt
j linepdt for year t in over asset turnjt
Other terms have usual meanings
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k R E R Re f m f ( ( ) )
CAPITAL ASSET PRICING MODEL
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CAPITAL ASSET PRICING MODEL CAPITAL ASSET PRICING MODEL
Key issues:Risk-free rateRisk premium
Arithmetic mean vs geometric meanBeta estimation issue
Choice of estimation periodChoice of return intervalChoice of market indexTendency to regress to oneAccuracy measurement
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Means ControversyMeans Controversy
Suppose you bought a share for Rs 100. Next year the price of the share went up to Rs. 200 and in the subsequent year fell down to Rs. 100. What is your rate of return?Arithmetic return = [+100% +(-)50%]/2 = 25%Geometric return = [100/100](1/2) –1 = 0%
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Means ControversyMeans Controversy
100
200
400
50
25
100
Prob. of up or down is 0.5Div=0
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Means ControversyMeans Controversy
100
200
400 × 0.25 =100
50
25 × 0.25 = 6.25
100 × 0.50 = 50
Expected Price = 156.25This is same as 100×(1.25) ×(1.25) = 156.25
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Adjustment for tendency to regress to oneAdjustment for tendency to regress to one
Method: One-third of distance to goal lineAtulya’s beta is 1.48Adjustment |(Raw beta –1)|/3Thus adjusted beta = 1.48 – [|(1.48-1)|/3] = 1.32If Meghana’s beta is 0.52. Then adjusted beta is?
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Adjustment for tendency to regress to oneAdjustment for tendency to regress to one
Method: One-third of distance to goal lineMeghana’s beta is 0.52Adjustment |(Raw beta –1)|/3Thus adjusted beta = 0.52 + [|(0.52-1)|/3] = 0.68
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Precision weighted peer group betaPrecision weighted peer group betaCompany D/V
MV Basis
MV of Equity
Est. Beta
Std. Err. Of beta
A 0.25 200 1.20 0.35
B 0.00 1150 0.80 0.20
C 0.14 850 0.85 0.25
D 0.36 500 0.75 0.46
Tax rate is 20%
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Precision weighted peer group betaPrecision weighted peer group beta
Company
Unleverd beta
Precision of beta
Precision weight
Weight* Beta(UL)
A 0.947 8.1632653 0.151 0.143
B 0.800 25 0.464 0.371
C 0.752 16 0.297 0.223
D 0.517 4.7258929 0.88 0.045
Average = 0.782
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Cost of DebtCost of Debt
Cost of debt is not the coupon rateCost of debt is the yield to maturity
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Yield to Maturity (YTM)Yield to Maturity (YTM)
is that discount rate that makes the PV of the promised future cash flows equal to the current market price of the bond (IRR)the rate of return to an investor if she holds the bonds to maturity and if the coupons are reinvested at the YTM
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YTM computationYTM computation
Pr( ) ( )
iceCoupon
rFaceValue Coupon
rii
n
1 1
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Cost of Capital to GOICost of Capital to GOI
Source ofFunds
Amt(Rs. Crs.)
CostAssigned
WeightedCost
Taxation 4044 10 40440PSESurplus
1431 10 14310
Loans,SmallSavingsand Debt
6538 8 39228
ExternalAssistance
2087 4 8348
Deficitfinancing
2060 15 30900
Total 16160 133226
Weighted Cost = 133226/16160 = 8.24% (approx.)
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STEPS IN A DCF VALUATION …contdSTEPS IN A DCF VALUATION …contd
Estimate the continuing valueDetermine the relationship between continuing value and DCFDecide forecast horizonDiscount to the present
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STEPS IN A DCF VALUATION …contdSTEPS IN A DCF VALUATION …contd
Estimate the continuing valueSelect appropriate techniqueSelect forecast horizonEstimate parametersDiscount to present
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Deciding on the length of forecastDeciding on the length of forecast
Explicit forecast periodContinuing value forecast
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STEPS IN A DCF VALUATION …contd STEPS IN A DCF VALUATION …contd
Calculating and interpreting resultsDevelop and test resultsIntegrate results within decision context
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STEPS IN A DCF VALUATION …contd STEPS IN A DCF VALUATION …contd
TestsIs th result consistent with the value drivers implicit in forecast?Resulting value vs Market value?Do any results require special explanations?Are the financial aspects achievable and desirable?
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STEPS IN A DCF VALUATION …contd STEPS IN A DCF VALUATION …contd
InterpretClearly identify value drivers and key assumptionsHow much the variables can change without changing decisionsLikelihood of changes in key assumptions
Environment, competitive structure, internal competenceDevelop alternative scenarios
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Final pointsFinal points
Avoid short-cutsAvoid hockey sticksBe realistic about synergiesOff Balance sheet items
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Thank youThank you