Valuation Approaches .pptx

Valuation Approaches

1. Corporate Valuations Basics and Methods

2. Basis for all valuation approaches The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value

3. Methods of Valuation DCF (Intrinsic valuation) , relates the value of an asset to its intrinsic characteristics: its capacity to generate cash flows and the risk in the cash flows. In it’s most common form, intrinsic value is computed with a discounted cash flow valuation, with the value of an asset being the present value of expected future cashflows on that asset Relative valuation , estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales Contingent claim valuation , uses option pricing models to measure the value of assets that share option characteristics

4. DCF Valuation

5. Discounted Cash Flow Valuation 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 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

6. Basis of intrinsic Valuation (DCF)

7. A few important terms Cost of capital , from the perspective on an investor, is the minimum return expected by whoever is providing the capital for a business Cost of Debt – Return expected by debt providers Cost of Equity - Return expected by equity shareholders Weighted Average Cost of Capital (WACC) - calculation of a firm's cost of capital in which each category of capital is proportionately weighted Beta – measure of the volatility, or systematic risk, of an asset in comparison to the market as a whole Risk-free rates - theoretical rate of return of an investment with zero risk

8. Estimating Inputs: Cost of Capital (WACC)

9. Estimating Inputs: Cost of Equity (CAPM Model) (about ~8% in India currently)

10. Estimating Inputs: Beta

11. Determinants of beta higher betas

12. Estimating Inputs: Cost of Debt The cost of debt is the rate at which you can borrow at currently. It will reflect not only your default risk but also the level of interest rates in the market The two most widely used approaches to estimating cost of debt are: Looking up the Yield to Maturity (YTM) on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm

13. Estimating Inputs: Cashflows Two pathways to the same goal Free Cash Flow to Firm (FCFF) – Free cash flow to the firm (FCFF) represents the cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments Free Cash Flow to Equity (FCFE) - Free cash flow to equity calculates how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid

14. Measuring FCFFs

15. Measuring FCFEs Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures Depreciation) - (Change in Non cash Working Capital) + (New Debt Issued - Debt Repayments) Or Free Cash Flow to Equity (FCFE) = FCFF + New Debt Issued - Debt Repayments – Interest on Debt

16. DCF: Two basic proposition

17. DCF choices: Equity Valuation vs Firm Valuation

18. Things to remember…

19. Getting Closure in Valuation: Terminal Value

20. Estimating Terminal Value So, using FCFFs, Terminal Value is TV = FCFF n+1 WACC - g Where, g = Return on Capital (RoC) * (1 – FCFF / EBIT(1-t)) Using FCFEs, Terminal Value is TV = FCFE n+1 Cost of Equity - g Where, g = Return on Equity (RoE) * (1 – FCFE / Net income)

21. DCF Model (FCFF) ( F CF E) ( W A CC)

22. DCF Model Enterprise value (Value of the firm) Equity Value P T is Terminal value for FCFE And K E is cost of equity

23. Moving between valuation metrics

24. Important learnings: Value enhancements The overall value of the company can be enhanced through: Increase in Cash flows from the assets in place Increase in expected growth Increasing length of the growth period Reducing cost of capital

25. Value creation 1: Increase in Cash flows from the assets in place

26. Value creation 2: Increase in expected growth

27. Value creation 3: Increasing length of the growth period

28. Value creation 4: Reducing cost of capital

29. Relative Valuation

30. Relative Valuation What is it: The value of any asset can be estimated by looking at how the market prices “similar” or ‘comparable” assets. Philosophical Basis: 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 (also called multiples) 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.

31. Steps in relative valuation

32. Estimating standardized values: Multiples

33. Important multiples: PE (Price-to-Earnings)

34. Using multiples for valuation: Example ABC Ltd. has earnings-per-share (EPS) of $12. DEG Ltd., a company comparable to ABC with similar business and risk profile has an EPS of $10 and price per share of $150 Find the value ABC Ltd. PE multiple of DEG = Price per share/EPS = 150 / 10 => 15x Using PE of 15x, Value of ABC is Value of ABC = PE * EPS => 15 * 12 => $180 per share

35. Other important multiples EV/EBITDA (Enterprise Value-to-EBITDA) P/BV (Price-to-Book Value) PEG ratio ( Price/Earnings-to-Growth)

36. Commonly used multiples