Equity Valuation

Chetan G. Shah, CFA
The Valuation Process…
• Understanding the business: industry structure &
  attractiveness, demand-supply & long term pros...
Valuations: Approaches
• Absolute valuations: discounted cash flows
  where the cash flows could be dividends, free cash
 ...
Valuation: Absolute
                                  Discounted cash flows:

                                            ...
Computing FCFF

 FCFF = Net income available to common shareholders
         Plus: Net non-cash charges (like depreciation...
Computing FCFE

 Some of ways FCFE is calculated:

 FCFE = FCFF − Int (1 − TaxRate) + NetBorrowing

 FCFE = NI + NCC − FCI...
DCF - Illustration using FCFF
Y/E March                                              2011      2012       2013       2014 ...
DCF - Illustration using FCFF
FCFF                    =A15 + A16 + A17 + A18      8,056    220   3,320   6,575   8,445   1...
Valuation: Relative
1) Based on Methods of Comparables…
 involves using a price multiple to evaluate whether an asset is r...
Valuation: Relative
2) Based on Forecasted Fundamentals…
 An approach of relating a price multiple to fundamentals through...
Residual Income…
Residual income = Net income – Equity charge


   RI = NI − r × BVBeginning

               ∞
           ...
Appropriateness of model
•   DDM models are suitable for dividend paying stocks, where company has a
    discernible divid...
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Equity Valuation

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Overiew with DCF Illustration and appropriateness of models...

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Equity Valuation

  1. 1. Equity Valuation Chetan G. Shah, CFA
  2. 2. The Valuation Process… • Understanding the business: industry structure & attractiveness, demand-supply & long term prospects, competitive position and corporate strategies (Porter 5 forces). • Forecasting company performance: relevant economic & industry variables, company sales, earnings, financial position and free cash flows. • Selecting the appropriate valuation model – going concern, liquidation, operating & non-operating parts, intrinsic value and relative valuations. Should be consistent with the characteristics of the company, ownership perspective (majority or minority) and appropriate given the availability & quality of data. • Making investment decision, e.g. ex ante alpha and ex post alpha returns.
  3. 3. Valuations: Approaches • Absolute valuations: discounted cash flows where the cash flows could be dividends, free cash flow to firm or equity (FCFF or FCFE) • Relative valuations: P/E (trailing or leading), P/B, P/S, EV/EBITDA, Replacement value like EV/Ton for cement & steel businesses. Company multiples vs. industry peers or some benchmark on like to like basis. • Residual income: which is present book value plus the future stream of residual income which is net profit less equity charge.
  4. 4. Valuation: Absolute Discounted cash flows: ∞ CFt Dividends V0 = ∑ FCFE i =1 (1 + r ) t n D P FCFF V0 = ∑ t t + n n ∞ FCFEt t =1 (1+ r) (1+ r) ValueEquity = ∑ ∞ FCFFt (1 + r )t ValueFirm = ∑ i =1 ∞ Dt i =1 (1 + WACC )t V0 = ∑ t =1 (1 + r )t D0 (1 + g ) D ValueEquity = ValueFirm − MarketValueDebt V0 = = 1 r−g r−g Gordon Growth Model
  5. 5. Computing FCFF FCFF = Net income available to common shareholders Plus: Net non-cash charges (like depreciation, deferred taxes) Plus: Interest expense x (1-Tax rate) Less: Investment in fixed capital (FCInv) Less: Investment in working capital (WCInv) FCFF = NI + NCC + Int (1 − TaxRate) − FCInv − WCInv FCFF = CFO + Int (1 − TaxRate) − FCInv FCFF = EBIT (1 − TaxRate) + Dep − FCInv − WCInv FCFF = EBITDA(1 − TaxRate) + Dep (TaxRate) − FCInv − WCInv
  6. 6. Computing FCFE Some of ways FCFE is calculated: FCFE = FCFF − Int (1 − TaxRate) + NetBorrowing FCFE = NI + NCC − FCInv − WCInv + NetBorrowing FCFE = CFO − FCInv + NetBorrowing FCFE = EBIT (1 − TaxRate) + Dep − Int (1 − TaxRate) − FCInv − WCInv + NetBorrowing FCFE = EBITDA(1 − TaxRate) + Dep (TaxRate) − FCInv − WCInv + NetBorrowing
  7. 7. DCF - Illustration using FCFF Y/E March 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 No of units mn Key assumption 10,000 10,000 18,000 26,000 31,000 36,000 41,000 46,000 51,000 51,000 ASP (Rs / units) Key assumption 4.50 4.50 4.00 3.75 3.50 3.50 3.50 3.50 3.50 3.50 Sales (INR mn) =A4 * A5 45,000 45,000 72,000 97,500 108,500 126,000 143,500 161,000 178,500 178,500 EBIT margins Key assumption 23.5% 23.5% 20.0% 18.0% 18.0% 18.0% 17.0% 16.0% 15.0% 15.0% Effective tax rate Key assumption 18.1% 18.1% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% NCC / sales Key assumption 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 4.8% 4.5% 4.0% 4.0% WC Inv / Sales Key assumption -1.3% -1.5% -1.5% -1.5% -1.5% -1.0% -1.0% -1.0% -1.0% -1.0% EBIT = A6 * A9 10,575 10,575 14,400 17,550 19,530 22,680 24,395 25,760 26,775 26,775 EBIT * (1-tax rate) = A14 * (1 - A10) 11,410 8,665 10,800 13,163 14,648 17,010 18,296 19,320 20,081 20,081 NCC = A6 * A11 2,250 2,250 3,600 4,875 5,425 6,300 6,816 7,245 7,140 7,140 WCInv = A6 * A12 (604) (694) (1,080) (1,463) (1,628) (1,260) (1,435) (1,610) (1,785) (1,785) FCInv Forecasted (5,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (5,000) FCFF =A15 + A16 + A17 + A18 8,056 220 3,320 6,575 8,445 12,050 13,678 14,955 15,436 20,436 WACC = A33 * A29 + A34 * A26 11.82% Risk free return Key assumption 7.50% Beta (Estimated) Key assumption 1.20 Free Cash Flow to Firm Risk premium Key assumption 8.00% Discount rate for Equity = A23 + A24 * A25 17.10% FCFF = Yield on 10yr Corp. bond Key assumption 10.000% Tax rate Key assumption 18.00% EBIT*(1-Tax rate) Discount rate for debt =A27 * (1 - A28) Estimated debt in 2011 Forecasted 8.20% 61,250 + Non Cash Charge (NCC) Estimated equity in 2011 Forecasted 41,942 – Investment in Working Capital (WCInv) Total capital employed Forecasted 103,192 Weight of Debt =A30 / A32 59.36% – Investment in Fixed Assets (FCInv) Weight of Equity =A31 / A32 40.64% Total weight 100.00% Continued on next page
  8. 8. DCF - Illustration using FCFF FCFF =A15 + A16 + A17 + A18 8,056 220 3,320 6,575 8,445 12,050 13,678 14,955 15,436 20,436 WACC = A33 * A29 + A34 * A26 11.82% Risk free return Key assumption 7.50% Beta (Estimated) Key assumption 1.20 Risk premium Key assumption 8.00% Discount rate for Equity = A23 + A24 * A25 17.10% Yield on 10yr Corp. bond Key assumption 10.000% Tax rate Key assumption 18.00% Discount rate for debt =A27 * (1 - A28) 8.20% Value of Equity= Estimated debt in 2011 Forecasted 61,250 Estimated equity in 2011 Forecasted 41,942 Value of Firm Total capital employed Forecasted 103,192 Weight of Debt =A30 / A32 59.36% - Value of Debt Weight of Equity =A31 / A32 40.64% Total weight 100.00% Present value of FCFF =NPV(C21, D19:M19) 49,672 Terminal Value (2020) =M19 / A21 172,934 Present value of TV =A38 / (1+A21)^(1/10) 56,596 Enterprise Value =A37+A39 106,269 Debt 61,250 Equity value (INR mn) =A40 - A41 45,019 No of shares (mn) 472.45 Price =A42 / A43 95.29 Spreadsheet models are very flexible in the sense that they provide an ability to value any pattern of expected free cash flow.
  9. 9. Valuation: Relative 1) Based on Methods of Comparables… involves using a price multiple to evaluate whether an asset is relatively fairly valued, undervalued or overvalued when compared to a benchmark value of the multiple. Name M-CAP EV/EBITDA P/E Year INR mn 1FY 2FY 3FY 1FY 2FY 3FY X1 43,066 5.5 4.5 4.5 10.3 9.2 8.3 X2 276,362 24.8 23.9 20.0 21.6 20.5 18.1 X3 73,324 10.6 12.1 10.8 13.3 15.1 13.0 X4 239,775 9.4 8.1 6.5 14.3 13.7 10.7 X5 13,537 8.5 4.7 4.6 15.5 10.2 9.7 Average (Peer) 129,213 11.8 10.7 9.3 15.0 13.8 11.9 Name P/B ROE Year 1FY 2FY 3FY 1FY 2FY 3FY X1 1.1 1.0 0.8 11.5 11.2 11.1 X2 2.0 1.8 1.4 9.2 8.8 7.9 X3 1.7 2.1 1.8 12.0 15.0 15.0 X4 2.3 2.0 1.7 14.6 14.5 17.8 X5 1.1 1.0 1.0 7.2 9.1 10.3 Average (Peer) 1.6 1.6 1.3 10.9 11.7 12.4
  10. 10. Valuation: Relative 2) Based on Forecasted Fundamentals… An approach of relating a price multiple to fundamentals through a DCF model. P/E P/B P/S P0 D1 / E1 1 − b P0 ROE − g P0 ( E0 / S0 )(1 − b)(1 + g ) = = = = E1 r−g r−g B0 r−g S0 r−g P0 D0 (1 + g ) / E0 (1 − b)(1 + g ) = = E0 r−g r−g Assuming stable growth, g…
  11. 11. Residual Income… Residual income = Net income – Equity charge RI = NI − r × BVBeginning ∞ ( ROEt − r ) × Bt −1 V0 = B0 + ∑ t =1 (1 + r )t Similar to EVA concept Current book value forms major part of the intrinsic value
  12. 12. Appropriateness of model • DDM models are suitable for dividend paying stocks, where company has a discernible dividend policy that has understandable relationship to its profitability and investor has a minority ownership perspective. • FCF approaches might be appropriate when company does not pay dividends or dividends differ substantially from cash flows, FCF align with profitability or investors take a majority control perspective. • The residual income approach can be useful when the company does not pay dividends or free cash flow is negative. • The key idea behind the use of P/Es is that earning power is a chief driver of investment value. • EV/EBITDA maybe more appropriate than P/E for comparing companies with different amounts of financial leverage (debt). Frequently used for capital intensive business. • Book value is viewed as appropriate for valuing companies having mainly liquid assets such as those in BFSI segment. Also useful when companies are not expected to continue as a going concern.
  13. 13. Thank you

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