Thesis Abdurrahman Ozturk

Chapter: Introduction Sep-15FMP | SEPTEMBER 2015ABDURRAHMAN ÖZTÜRK | STUDENT N° 132 507

© Copyright by Abdurrahman Öztürk 2015
All Rights Reserved.
The copyright of this paper rests with the author. The author is solely responsible for the content of
the paper, including mistakes.

Title :
Valuing Emerging Market Companies: The Turkish
Case
Program: MSc - FIN 7 - London (2013 - 2015)
Academic Year: 2013-2014
Dissertation / Project / Internship Report: Final Management Project 2013-2014
Student Name: Ozturk Abdurrahman
School Tutor / Evaluator Name: Mchawrab Safwan
Summary: There are myriads of valuation models and the most commonly used
valuation models are Discounted Cash Flow, Accounting Valuation and Relative
Valuation. This academic paper revolves around valuation of emerging market
firms, and particularly Turkish Firms. The data analysis in this research has
shown that the risks considered in valuing Turkish firms do not differ majorly from
the valuation of other emerging market (EM) firms. Besides this, it is found that
the risks observed in the analysis can be allocated into two categories: systemic-
risk and company-related-risk. Furthermore, we find investors tend to use
multiple-valuation merely as guidance and apply the DCF valuation to estimate
the real value of the firm. Finally, the result of the research shows that there is no
one model that acts as a benchmark for estimating the required rate of return of
Turkish firms. This is since different investors and analysts tend to have different
perspectives when assessing a company.
Keywords: (cf. Thesaurus du Management):
TURKISH
EVALUATION OF A COMPANY
MARKET CAPITALIZATION
CORPORATE FINANCE
To be filled in by the student
□Non Confidential □Confidential

i
I. ABSTRACT
There are myriads of valuation models and the most commonly used valuation models are
Discounted Cash Flow, Accounting Valuation and Relative Valuation. This academic paper
revolves around valuation of emerging market firms, and particularly Turkish Firms. The data
analysis in this research has shown that the risks considered in valuing Turkish firms do not
differ majorly from the valuation of other emerging market (EM) firms. Besides this, it is
found that the risks observed in the analysis can be allocated into two categories: systemic-
risk and company-related-risk. Furthermore, we find investors tend to use multiple-valuation
merely as guidance and apply the DCF valuation to estimate the real value of the firm.
Finally, the result of the research shows that there is no one model that acts as a benchmark
for estimating the required rate of return of Turkish firms. This is since different investors and
analysts tend to have different perspectives when assessing a company.

Table of Content
I. ABSTRACT I
II. DECLARATION II
III. ACKNOWLEDGMENT III
1 INTRODUCTION 1
1.1 RESEARCH QUESTION AND OBJECTIVES 2
1.2 RESEARCH LIMITATION 2
1.3 PAPER OUTLINE 2
2 VALUATION MODELS 3
2.1 DISCOUNTED CASH FLOW VALUATION 4
2.1.1 DCFs On An Asset (or Business) At A Risk-Adjusted Discount Rate 5
2.1.1.1 Equity Valuation 5
- Dividend Discount Model 5
- Free Cash flow to Equity 6
- Dividend Discount Model vs Free Cash Flow to Equity 7
2.1.1.2 Firm Valuation 8
2.1.2 Developing A Discount Rate 9
2.1.2.1 Weighted Average Cost of Capital 9
2.1.2.2 Cost of debt 10
2.1.2.3 Cost of Equity 11
- Risk Free Rate 11
- Beta 12
- Market Risk Premium 13
2.1.2.4 Weighted Average 15
2.2 ACCOUNTING OR BOOK VALUATION 15
2.3 RELATIVE VALUATION 16
2.3.1 Price/ Earnings ratio 17
2.3.2 Price/Book value 18
2.3.3 Price/Sales ratio 18
3 VALUATION IN EMERGING MARKETS 19
3.1 HISTORY OF EMERGING MARKETS 20
3.2 CHARACTERISTICS OF EMERGING MARKET FIRMS 20
3.3 LIMITATIONS IN EMERGING MARKET FIRMS 22
3.4 INTEGRATING THE LIMITATIONS 23
4 VALUATION IN THE TURKISH MARKET AND REVIEW OF
RELATED LITERATURE 24

5 RESEARCH METHODOLOGY 28
5.1 RESEARCH METHODOLOGY 28
5.1.1 Research Philosophy 28
5.1.2 Research Approach 28
5.1.3 Research Design 29
5.1.3.1 Research Purpose 29
5.1.3.2 Research Strategy 29
5.1.3.3 Research Choice 29
5.1.3.4 Time-Horizons 30
5.1.4 Data Collection Method 30
5.1.4.1 Secondary Data Collection 30
5.1.4.2 Primary Data Collection 31
5.1.5 Questionnaire Design 31
5.1.6 Sampling 32
6 DATA ANALYSIS 34
6.1 QUESTIONNAIRE RESULT 34
6.1.1 The Characteristics of Emerging Market Companies 34
6.1.2 A Particularity in Valuing Listed Emerging Market Companies 35
6.1.3 Risks in Turkish Companies 37
6.1.4 Valuation Model/Tool Used When Valuing A Turkish Company 38
6.1.5 The Benchmark for Estimating the Required Returns in Emerging Markets 40
6.2 ADDITIONAL RESEARCH 41
6.2.1 Identified Characteristics of Turkish Companies 41
6.2.2 Valuation Tools Used By Analysts 44
6.2.3 Illustrating Garanti Securities’ Valuation of Gubretas 44
6.3 LIMITATIONS 47
7 CONCLUSION 48
IV. REFERENCES V

List of Tables
TABLE 1 RESPONDENTS OVERVIEW 33
TABLE 2 REPORT DETAILS 41
TABLE 3 GUBRETAS -FREE CASH FLOW PROJECTIONS FOR DOMESTIC OPERATIONS (TL MN) 45
TABLE 4 GUBRETAS - FREE CASH FLOW PROJECTIONS FOR RAZI (US$ MN) 46
List of Figure
FIGURE 2-1 VALUATION MODELS 3
List of Equations
EQUATION 2-1 THE GENERAL MODEL 5
EQUATION 2-2 THE GORDON MODEL 6
EQUATION 2-3 THE TWO-STAGE DIVIDEND DISCOUNT MODEL 6
EQUATION 2-4 FREE CASH FLOW TO EQUITY (POTENTIAL DIVIDENDS) 7
EQUATION 2-5 DISCOUNTED FREE CASH FLOW TO EQUITY (POTENTIAL DIVIDENDS) 7
EQUATION 2-6 FREE CASH FLOW TO EQUITY (ACTUAL DIVIDENDS) 7
EQUATION 2-7 VALUE OF EQUITY 7
EQUATION 2-8 FREE CASH FLOW TO FIRM 8
EQUATION 2-9 MARKET VALUE OF FIRM 9
EQUATION 2-10 WEIGHTED AVERAGE COST OF CAPITAL 10
EQUATION 2-11 PRE-TAX COST OF DEBT 10
EQUATION 2-12 INTEREST RATE COVERAGE 10
EQUATION 2-13 COST OF DEBT 11
EQUATION 2-14 CAPITAL ASSET PRICING MODEL 11
EQUATION 2-15 UNLEVERED BETA 13
EQUATION 2-16 LEVERED BETA 13
EQUATION 2-17 ADJUSTED EQUITY FOR RISK 14
EQUATION 2-18 MARKET VALUE OF EQUITY 15
EQUATION 2-19 MARKET VALUE OF DEBT 15
EQUATION 2-20 WEIGHTED AVERAGE OF DEBT 15
EQUATION 2-21 WEIGHTED AVERAGE OF EQUITY 15
EQUATION 2-23 BOOK VALUE OF EQUITY 16
EQUATION 2-25 PE-RATIO 17
EQUATION 2-26 PE-RATIO 17

EQUATION 2-27 PRICE TO BOOK RATIO 18
EQUATION 2-28 PRICE TO BOOK RATIO 18
EQUATION 2-29 PRICE-TO-SALES RATIO 19
EQUATION 2-30 PRICE TO SALES RATIO 19
EQUATION 2-31 PRICE TO SALES RATIO 19
EQUATION 3-1 BOOK INTEREST RATE 22
EQUATION 3-2 LAMBDA 24
EQUATION 3-3 LAMBDA REVENUE MEASURE 24
EQUATION 3-4 LAMBDA REGRESSION 24

ii
II. DECLARATION
I, Abdurrahman Öztürk, declare that this dissertation was carried out in accordance with
the rules and regulation of Grenoble Graduate School of Business. A full list of the references
used has been included. The dissertation has not been presented to any other university.

iii
III. ACKNOWLEDGMENT
Firstly, I would like to significantly thank my advisor PhD Safwan Mchawrab for the
continuous support of my MSc study and related research, for his patience, motivation, and
immense knowledge. His guidance helped me in all the time of research and writing of this
thesis and his dedication to my work is very much appreciated.
Besides my advisor, I would like to thank my colleague at GE Capital: Kashif Bhatti, for
reviewing my dissertation and providing me with insightful comments.
I thank my fellow classmates for the stimulating discussions, for the sleepless nights we
were working together before deadlines, and for all the fun we have had in the last two years.
Also I thank Agbab Alex Pethke and Romano Audhou. In particular, I am grateful to
Ramazan Kat for helping me in designing the cover page.
My sincere thanks also goes to Ozcan Kocak, Serhat Erken and Yusuf Kinik, who provided
spiritual support during my period at my MSc study. Last but not the least, I would like to
thank my family: my parents and to my brothers and sister for supporting me spiritually
throughout writing this thesis and my life in general.

VALUING EMERGING MARKET COUNTRIES: The Turkish Case
Page 1
1 INTRODUCTION
The methods of valuation are subjective since they are based upon an individual’s
assumption. There are myriads of valuation models and the most commonly used valuation
models are:
1. Discounted Cash Flow (DCF): the sum of the expected cash flows of the
assets, discounted at a rate that should represent the riskiness of the cash flows
2. Accounting Valuation: the book value of the assets on a balance sheet
3. Relative Valuation: the value of an asset compared to the values assessed by
the market for similar or comparable assets.
Based upon the research about the gap between the theory and practice of corporate
valuation conducted by Frank Bancel and Usha R Mittoo in 2014, it was found that the DCF
and Relative Valuation are the most popular models used by financial practitioners but most
of the inputs of the DCF model used by practitioners vary substantially.
The emerging market economies are booming and industrializing quickly. (Van Agtmael,
2007), which has attracted global investors. Although corporate finance experts and scholars
have a good understanding of valuing companies in developed economies, there is still not a
general consensus about valuing Emerging Market (EM) companies. Therefore, valuation of
EM firms have become challenging and more demanding as there is a requirement for real
time valuation added with incorporation of the risk parameters.
Turkey has attracted global investors for many reasons. The country eliminated its autarkic
inward-oriented economy and has become one of the region’s most liberal investment regimes
(Tatoglu and Glaister, 1998). According to the Turkish Investment Support and Promotion
Agency, Turkey’s booming economy tripled its Gross Domestic Product (GDP) from USD
231 billion in 2002 to USD 800 billion in 2014. Moreover, Turkey is expected to become one
of the fast growing economies among the Organisation for Economic Co-operation and
Development members (OECD). Turkey’s demographic of young and well-educated
population establishes promise of accelerating economic growth going forward. Lastly,
Turkey has an immense domestic market whose consumption level considerably increased
over the last decade.
Following the liberalization of the Turkish economy in the early 2000s, Mergers and
Acquisitions (M&A) have considerably increased. M&A transactions that barely reached a
volume of US$ 1 billion until 2002 have significantly increased in 2014, to a total M&A deal
volume of around US$21 billion. (Deloitte, 2014) In term of Foreign Direct Investment (FDI)

Chapter: Introduction Sep-15
Page 2 Abdurrahman Öztürk
inflow the World Investment Report notes that Turkey has moved up in the world ranking
from 24th in 2012 to 22nd in 2013, attracting US$ 12.9 billion.
1.1 RESEARCH QUESTION AND OBJECTIVES
This academic paper revolves around valuation of emerging market firms and therefore,
the research question is:
How do investors value emerging market companies and in particular Turkish firms?
The objective of the research question is to define:
- the characteristics of emerging market companies
- a specific valuation tool when valuing emerging market companies
- the type of risks that is carried by Turkish firms
- the preferred valuation tool for valuing a Turkish firm.
1.2 RESEARCH LIMITATION
The sample taken for the questionnaire research does not represent the total population of
Turkish market analysts since it is not randomly selected and as only participant that
volunteered are included in the research. Furthermore, the questionnaire is limited to the
participant’s opinion and experience in valuation. The additional research covers specific
industries of the Turkish Market, hence the examples given cannot be generalized to other
emerging markets or industries.
1.3 PAPER OUTLINE
Chapter 2 discusses the different valuation models that are used by practitioners. Chapter 3
presents the existing research papers about valuation of emerging market firms. Chapter 4
describes mainly the development of the Turkish Stock Market. Then, in chapter 5, the
methodology of the research is presented, elaborating on the chosen research design and data
collection. Finally, the research results are discussed in chapter 6, followed by a conclusion in
chapter 7.

Page 3
2 VALUATION MODELS
There are many valuation models but this part will demonstrate the most important and
frequently used valuation models. Frank Bancel and Usha R Mittoo (2014) organized a
survey1
–among 365 finance practioners in a variety of European countries with CFAs or
equivalent degrees– to identify differences among valuation experts. Pursuant to the survey,
DCF and Relative Valuation are the most popular valuation tools.
Figure 1.1 presents an overview of the three main valuation models – DCF, Accounting
and Relative valuation – which are illustrated in this chapter.
First, Discounted Cash Flow valuation (henceforth DCF) determines the value of a firm or
asset by the sum of expected future cash flow discounted by an appropriate risk-rate. Second,
the Accounting valuation is developed to project the value of an asset or firm through
accounting estimates or book value. Third, the Relative Valuation estimates the value of asset
by looking at the pricing of comparable assets to relative to a common variable like earnings,
book value or sales.2
Figure 2-1 Valuation Models
1
Franck Bancel and Usha R.Mittoo, “The gap between the theory and Practice of Corporate Valuation: Survey of European Experts”,
Applied Corporate Finance (Fall 2014): p 106-117
2
Aswath Damodaran, “Valuation Approaches and Metrics A Survey of theory and evidence”, Stern School of Business Working paper,
November 2006, 1-77, P1
Valuation
DCF
Risk Adjusted Discount
Rate
Firm Valuation
Equity Valuation
Certainty Eequivalent
Cash Flow
Adjusted Present
Value
Excess Return
Accounting Relative Valuation

Chapter: Valuation Models Sep-15
2.1 DISCOUNTED CASH FLOW VALUATION
According to Damodaran (2006), DCF is the present value of the expected cash flows of
the asset, discounted at a rate that represents the riskiness of the Cash flows. If Assets or firms
have higher cash flows and are more predictable, they are less risky hence their value is
higher.
Calculation of present value is something neither new nor revolutionary; one can say that it
dates back to 14th century – where Francesco Balducci Pegolotti prepared the interest rates
table. Further to this, in 1582, Simon Stevin explained the basics of the present value.3
During
the second half of the nineteenth century, A.M. Wellington, argued that the time value of
money should be compared to the cost of the investment that occurs at the beginning.4
Nevertheless, DCF valuation models have become very complex (Patena, 2011). It can be
difficult understand the models and recognize the underlying assumptions for the valuation
process. Patena (2011) argues that sensitivity analysis improves the objectivity of the model
and eliminates the exposure for possible manipulation and should therefore be considered as a
standard step in DCF models. In addition, Richard S. Ruback (2011) believes that in practice
forecasts contains upwardly biased estimates of the expected cash flow. Generally,
practitioners compensate the down-sides by surging the discount rate beyond the market rate
of cost of capital. However, initially, Ruback (2011) recommends determining whether the
downside is temporary or permanent. If it is temporary, “the base-case cash flow forecasts
should just be adjusted to the probability weighted average of the downside and the base cases
and values the deflated cash flows at the cost of capital. If permanent, valuation should be
done in two parts. First, the downside cash flows are discounted at the cost of capital. Second,
the difference between the base and downside forecast should be discounted at a rate that
equals the sum of the cost of capital and the probability that the downside will occur.”5
(Ruback, 2011)
Examining to Figure 2-1 on page 3, it is clear that DCF valuations are subsequently
iterated into four:
1. Discount expected cash-flows on an asset ( or business) at a risk-adjusted discount rate
2. Risk adjusted or certainty equivalent cash flows discount at risk-free rate
3. Adjusted present value approach
4. Value a business as a function of the excess returns
3
Stevin, S., 1582, Tables of Interest.
4
Wellington, A.M., 1887, The Economic Theory of the Location of Railways, Wiley, New York.
5
Richard S. Ruback, “Downsides and DCF: Valuing Biased Cash Flow Forecasts”, Applied Corporate Finance (Spring 2011): 8-17

Page 5
This research paper only elaborates on the first point as it is the most frequently used model
among practitioners and theorist.
2.1.1 DCFs On An Asset (or Business) At A Risk-Adjusted Discount Rate
There are two main types of DCF models:
a) Equity valuation: “the cash flows after debt payments and reinvestment needs are
called free cash flows to equity and the discount rate that reflects just the cost of the
equity financing is cost of equity.” (Damodaran, 2006)
b) Firm Valuation: ”the cash flows before debt payments and after reinvestment needs
are termed free cash flows to the firm, and the discount rate that reflects the composite
cost of financing from all sources is the cost of capital” (Damodaran, 2006)
2.1.1.1 Equity Valuation
Equity valuation models compute the shareholders’ value of a business by discounting the
expected cash flow to equity at a rate of return that reflects the equity risk of the firm. There is
a general consensus that Dividend Discount Model and Free Cash Flow to Equity are the two
main models which are used for estimating the equity valuation.
- Dividend Discount Model
Dividend discount models –the simplest model for valuing equity– is the sum of present
value of expected dividend payments. Given that, this part reviews the general model, Gordon
Model and the two-stage model.
With the General Model, the types of cash flows expected by investors are dividends and
the stock price received at the end of the period when selling the stock. “Since this expected
price is itself self-determined by future dividends, the value of a stock is the present value of
dividends through infinity.” (Damodaran, 2006)
Equation 2-1 The General Model
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 = ∑
𝐸(𝐷𝑃𝑆𝑡)
(1 + 𝑘 𝑒) 𝑡
𝑡=∞
𝑡=1
where,
E(DPS t) = Expected dividends per share in period t, ke = Cost of equity
There are two basic inputs to the model – expected dividends and the cost of equity.6
In
order to determine the expected dividends, the future growth rates in earnings as well as
6
Aswath Damodaran, “Dividend Discount Models”, Stern School of Business Working paper, Chapter 13

dividend pay-out ratio will be assessed. To acquire the cost of equity, CAPM, APM and
Multifactor models 7
are occasionally used.
In 1962, Myron J. Gordon popularized the Dividend Discount Model known as the Gordon
Model that is applicable for companies with growth rates that are slightly lower than the GDP
increase of the operating country and companies with constant dividend pay-out ratio.
Equation 2-2 The Gordon Model
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 =
𝐷𝑃𝑆1
𝑘 𝑒 − 𝑔
where,
DPS1 = Expected Dividends one year from now (next period) ke= Required rate of return for equity investors g =
Growth rate in dividends forever
The Gordon model – which is shown in Equation 2-2– is applicable for businesses that
have a sustainable growth rate. Since the growth rate in the firm’s dividend is in perpetuity,
Damodaron articulates that the dividend growth rate cannot override the growth rate of the
economy. To illustrate, ”When earnings growth 3% and dividend grows 4%, over the long
term, dividend will exceed. In opposite, when earnings grow 4% and dividend grows 2%,
over time, dividend will converge near zero.” (Damordaron, 2006)
The two-stage dividend discount model provides for two stages of growth. The initial stage
is designated as having a non-steady growth rate whereas the second stage of the model
assumes that the growth rate is consistent and in perpetuity. Therefore, the value of a stock is
the sum of the present value of dividends in the first stage and the present value of the
terminal price.
Equation 2-3 The Two-Stage Dividend Discount Model
𝑃0 = ∑
𝐷𝑃𝑆𝑡
(1 + 𝑘 𝑒,ℎ𝑔)𝑡
+
𝑃𝑛
(1 + 𝑘 𝑒,ℎ𝑔) 𝑛
+ where 𝑃𝑛 =
𝐷𝑃𝑆 𝑛+1
(𝑘 𝑒,𝑠𝑡 − 𝑔 𝑛)
𝑡=𝑛
𝑡=1
where,
DPSt = Expected dividends per share in year t ke = Cost of Equity (hg: High Growth period; st: Stable growth
period) Pn = Price (terminal value) at the end of year n g = Extraordinary growth rate for the first n years gn = Steady
state growth rate forever after year n
Source: Damodaron; Dividend Discount Model Chapter 13; page 8
Damodaran (2006) believes that this model has some limitation as it is difficult to delineate
the extraordinary growth period. In addition, he argues that it is unrealistic when a high
growth rate applied in the first stage immediately changes to a low growth rate.
- Free Cash flow to Equity
Another model that is used to value the Equity of a firm is the Free Cash Flow to Equity
(henceforth FCFE). The FCFE can be measured using two different approaches. On the one
7
Aswath Damodaran, “I. Estimating Discount Rates”, [URL: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/dcfrates.pdf ] in
proceeding of DCF explanation, Stern School of Business, slide 4

Page 7
hand, Damodaron and many practioners –“(e.g. Benninga and Sarig, 1997; Brealey and
Myers, 2003; Copeland,2 Koller and Murrin, 1994, 2000)”; describes the FCFE model as the
present value of potential dividends. The assumption of this model – that is shown in
Equation 2-4 – is that all excess cash will be paid out to stock holders. It is important to note
that the model is developed to value firms that are growing at a stable rate.
Equation 2-4 Free Cash Flow to Equity (Potential Dividends)
𝑭𝑪𝑭𝑬 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
− 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − (𝑁𝑒𝑤 𝑑𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒𝑑 − 𝐷𝑒𝑏𝑡 𝑟𝑒𝑝𝑎𝑦𝑚𝑛𝑡𝑠)
Equation 2-5 Discounted Free Cash Flow to Equity (Potential Dividends)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = ∑
𝐹𝐶𝐹𝐸𝑡
(1 + 𝑘 𝐸)𝑡
𝑇
𝑡=1
+
𝑉𝑇
(1 + 𝑘 𝐸) 𝑇
, 𝑤ℎ𝑒𝑟𝑒 𝑉𝑇 =
𝐹𝐶𝐹𝐸 𝑇+1
𝑘 𝑒 − 𝑔
On the other hand, some authors –“(DeAngelo and DeAngelo, 2006, 2007; Fernández,
2002, 2007; Tham and Vélez-Pareja, 2004; Vélez-Pareja, 1999a, 1999b, 2004, 2005a,
2005b)”8
– support that FCFE model should only consider the present value of actual
dividends. According to Carlo A Magni and Ignacio V. Pareja (2009) the theory clearly
defines the value of an asset as the actual payment received by shareholders. Also, in their
analysis of the literature, they conclude that the market does not perceive the potential
dividend as a value driver. Potential dividends are admissible in valuation, only if the
investment is expected to be done at Cost of equity that has zero NPV.
Equation 2-6 Free Cash Flow to Equity (Actual Dividends)
𝑭𝑪𝑭𝑬 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 + 𝑆ℎ𝑎𝑟𝑒 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑛𝑒𝑤 𝑞𝑢𝑖𝑡𝑦 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
In essence, “The value of equity, under the constant growth model, is a function of the
expected FCFE in the next period, the stable growth rate and the required rate of return.”
(Damodaron, 2006)
Equation 2-7 Value of Equity
𝑃0 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐹𝐶𝐹𝐸1
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑆𝑡𝑎𝑏𝑙𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
- Dividend Discount Model vs Free Cash Flow to Equity
Even given the advantage of the DDM model requiring fewer assumptions, the model has
limitations. First of all, it will not be applicable when a firm does not pay dividends.
Secondly, dividends can be financed through external funds such as bond issues,
consequently, a DDM model can overvalue the Equity value. Therefore the DDM model
8
Carlo A. Magni and Ignacio V. Pareja, “Potential dividends and actual cash flows in equity valuation. A critical analysis”, Estudios
Gerenciales ( December 2009): 123-150

should be used either when free cash flow to equity is equivalent to dividend payment or Cash
Flow estimation is difficult.
When dividends are equal to FCFE, both equations will provide the same result. Similarly,
when the FCFE exceeds the dividend payment and the excess cash has been invested in yield
that results in a zero NPV, both equations will deliver the same value. However, FCFE could
present different results in two different situation. The first, when the excess cash ( FCFE
subtracted by dividend) is invested in a negative NPV asset, the FCFE will provide a higher
valuation. The second, when shareholders are paid lower dividends.
Foerster and Sapp (2011) have made a comparison between the Gordon Growth Model
(henceforth GGM) and the sophisticated forecasting models. It is clear that dividend-based
valuation methods, especially GGM, perform relatively well at explaining the actual prices of
the S&P composite Index between 1871 and 2010. It can be said that GGM undervalued
stocks until 1914, over-valued between 1914 and 1981 and objectively valued until 2010.9
(Foerster and Sapp, 2011) Although DDM is simple and it has been seen that dividend is the
only tangible cash flow to investors, FCFE has been considered as an alternative for DDM.
2.1.1.2 Firm Valuation
Firm Valuation is another DCF model that is used to compound the value of a firm. The
firm valuation –also well known as the Free Cash Flow to Firm (henceforth FCFF)– is the
cash flow to firm that consists of after-tax operating income, net of investments in capital and
net working capital. The cash flow in FCFF refers to both Debt holders and Equity holders.10
The first step of the Firm Valuation is to calculate the FCFF which is shown in Equation
2-8 below.
Equation 2-8 Free Cash Flow to Firm
𝑭𝑪𝑭𝑭 = 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
− 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
The second step is to calculate the present value of FCFF by discounting it by WACC,
which is an appropriate measure of the riskiness of firm’s assets and liabilities. As can be seen
from Equation 2-9 below, the market value of the firm can be allocated in two stages. The
first stage is assigned to non-steady growth rate. After calculating the cash flow, it has been
discounted by WACC which will be further explained in the next paragraph. In the second
stage, wherein the terminal value must be calculated, it is assumed that the growth rate is
9
Stephen R. Foerster and Stephen G. Sapp, “Back to fundamentals The role of expected cash flows in equity valuation”, North
American Journal of Economics and Finance (June 2011): 320
10
Zvi Bodie, Alex Kane and Alan J. Marcus, Investments and Portfolio Management, New York, McGraw-Hill Irwin, 2011, p 789-793,
p.2

Page 9
stable, consistent and indefinite. Therefore, the terminal value determines “the market value
of the free cash flow from the project at all future dates.”11
Equation 2-9 Market Value of Firm
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑖𝑟𝑚 = ∑
𝐹𝐶𝐹𝐹𝑡
(1 + 𝑊𝐴𝐶𝐶)𝑡
𝑇
𝑡=1
+
𝑉𝑇
(1 + 𝑊𝐴𝐶𝐶) 𝑇
, 𝑤ℎ𝑒𝑟𝑒 𝑉𝑇 =
𝐹𝐶𝐹𝐸 𝑇+1
𝑊𝐴𝐶𝐶 − 𝑔
where,
FCFEt= Free cash flow to Firm in year t, WACC=Weighted Average Cost of Capital, g= growth rate
In order to use the FCFF model, Damodaron argues that the following characteristics
should be met:
1. “the growth rate used in the model has to be less than or equal to the growth rate in
the economy – nominal growth if the cost of capital is in nominal terms, or real
growth if the cost of capital is a real cost of capital.
2. Characteristics of the firm have to be consistent with assumptions of stable growth
3. Reinvestment rate should be consistent in conjunction with the stable growth rate
4. The debt ratio of the firm is constant” Damodaron ( 2006)
2.1.2 Developing A Discount Rate
2.1.2.1 Weighted Average Cost of Capital
The rate used in discounting the projected cash flows in the DCF model is the Weighted
Average Cost of Capital – also well-known as the WACC. WACC allows investors to
understand the mix of debt and equity that affect the firm’s cost of capital and overall
corporate valuation.12
Berk and De Marzo (2014) claim that the value of the firm does not
depend on the finance structure of the firm. For instance, when a firm structures its finance
with more debt, the Cost of Equity will increase as the amount of debt increases, the debt
becomes more risky because there is a higher chance the firm will default. Although the Cost
of Equity increases, in essence, because the weight of Debt increases the WACC does not
change. Nevertheless, the cost of debt is cheaper than the cost of equity since it has some tax
benefits. In fact, increase in the leverage will also not shrink the WACC as the cost of Equity
increases.13
This section explains the steps in calculating an appropriate WACC for a DCF model. As it
can be seen from Equation 2-10 below, the WACC consist of three parts – the cost of debts,
the cost of capital and the weights of each of the variables.
11 Jonathan Berk and Peter DeMarzo, Corporate Finance, Essex, Pearson Education, 2014, p 250, p.3
12
Sam G. Berry Carl E. Betterton and Iordanis Karagiannidis, ‘’Understanding Weighted Average Cost of Capital A pedagogical
application’’, Journal of Financial Education, Spring/Summer 2014: 115
13
Ibid p.3, page 487-494

Equation 2-10 Weighted Average Cost of Capital
𝑊𝐴𝐶𝐶 = 𝑤 𝑑 𝑟𝑑(1 − 𝑇) + 𝑤𝑠 𝑟𝑠
, where
𝒘 𝒅= The proportion of total capital represented by debt, 𝒓 𝒅= interest rate on new debt (before tax), 𝒘 𝒔= The
proportion of total capital represented by equity, 𝒓 𝒔= rate on equity, T= Firms marginal tax rate
2.1.2.2 Cost of debt
One way of raising money is through issuing debt. A debt is a contractual agreement
between a borrower and a lender, where the borrower receives an agreed amount of money
(principal) for a fixed period of time in exchange to pay the lender a monthly fixed payment
(interest). One of the advantages of issuing debt for firms is that it is tax deductible on the
firm’s income tax return. The second benefit is that it does not dilute the ownership interest in
the firm by adding more owners.
Since the interest rates in the most markets are upward sloping, bonds with a longer
maturity have higher interest rates. If the cost of debt of firms is measured based on the actual
interest rate, companies might replace the long-term debt by short-term in order to reduce the
cost of debt. Therefore, regardless of the kind of debt – whether it is a long-term or short-term
debt – an analyst consolidates the firm’s debts and interprets it as a long term debt. Hence,
“the cost of debt is the rate at which you can borrow long term today – it will reflect not only
your default risk but also the level of interest rates in the market.” 14
Generally, cost of debt could be estimated using two main approaches. The first is to
measure the yield-to-maturity on the outstanding bonds of the firm. The only limitation is that
limited number of companies has market tradable bonds. The second is to use the ratings on
bonds with which as a consequence the default spread can be measured.
Equation 2-11 Pre-Tax Cost of Debt
𝑃𝑟𝑒 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑
However if both approaches are not applicable, Damodaran suggest to estimate a synthetic
rating for your firm and the cost of debt based upon that rating. The rating can be estimated by
using the interest coverage ratio. Instead of using the operating income for the latest year –
which might provide us with a misleading view of the risk in the company – the operating
income will be an average for a period of time in order to capture the stability or instability of
earnings overtime.
Equation 2-12 Interest Rate Coverage
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐸𝐵𝐼𝑇
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
14
Aswath Damodaran, ‘’Session 7 Defining and estimating the cost of debt’’, PowerPoint presentation, November11, 2011, NYU Stern
School of Business, New York

Page 11
The next step is to convert the interest rate coverage into a rating by using Damodaran’s
table15
followed by defining the company default spread. In addition, firms might attach the
country default spread for those firms that have the majority of their operations in countries
with low ratings and high default risk. Hence, the equation for cost of debt look as following:
Equation 2-13 Cost of Debt
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑 + 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑠𝑝𝑟𝑒𝑎𝑑
2.1.2.3 Cost of Equity
It is important to use a correct discount rate for both the riskiness and the type of cash flow
being discounted either in DDM and FCFE model. There should also be no currency
mismatch, therefore the same currency should be used for projecting expected cash flows as
well as calculating the discount rate. Moreover, if cash flow projections reflect expected
inflation – nominal cash flow – the discount rate should also be nominal.
When measuring the Dividend Discount Model and Free Cash Flow to Equity, one will use
the cost of equity. “A survey conducted in 2011 by the Association for Financial Professionals
on the use of asset pricing models for estimating the cost of capital found that 87% of all
firms and 91% of publicly traded firms use the CAPM” ( Michelfelder, 2015) Therefore, this
part presents the calculation method of cost of equity using the CAPM model. As it can be
seen from Equation 2-14, the CAPM model consist of the risk-free rate, Beta and the risk
premium.
Equation 2-14 Capital Asset Pricing Model
𝐸(ℛ) = ℛ𝑓 + 𝛽 ∗ (𝐸(ℛ𝓂) − ℛ𝑓)
where
𝑬(𝓡)= Expected return on the Market Index, 𝓡𝒇= Risk free Rate, 𝜷= Equity Beta
- Risk Free Rate
Generally governments cannot technically default, therefore the rate of a 10 year
government bond is usually used as a risk free rate. According to Damodaran even some
Governments bonds include a default risk. Therefore, a true risk free rate should neither
contain default risk nor reinvestment risk.
In order to be able to choose an appropriate risk-free rate, Damodaran argues that different
factors of the valuation should be taken into consideration. First of all, the time-horizon is an
important factor in deciding the risk-free rate. So, if it is about a long-term valuation, the risk-
free rate should also be from a long-term government bond. Secondly, for valuation of
inflation-free cash flows in USD currency, Treasury Inflation Protected Securities (TIPS) are
15
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.htm

used for risk-free rate since it represents government securities that are protected against
inflation.
Thirdly, when a company is valued in a currency other than USD, assuming in this case
EUR, many analysts will suggest using a Euro risk-free rate. Even though different euro
government bonds are available at different rates, it is assumed that the lowest rate would be
the one that represents the risk-free rate.
Furthermore, it should be noted that not every government bond is perceived as risk-free,
for instance, EMs bonds. The key number in order to measure the risk-free rate is the default
spread which should be excluded from the government’s treasury rate. In this case, there are
three main ways to determine the default spread. First, if the emerging market country issues
the bond in USD-currency, the difference between the US Bond rate and EMs Bond rate will
be the default spread. Second, it is possible to acquire the spread from the Credit Default
Swap markets (CDS). The CDS market provides insurance against default risk if you
purchased the bonds. The price of the CDS product for a particular country would be the
default spread. In addition to this, the CDS market is always up-to-date and provides you with
the current view of the market. Third, it is possible to define the default spread looking at
Damodaran’s average default spread table using the sovereign risk rating that is assigned by
the rating agencies like Fitch and Moody’s. Damodaran has prepared a table that summarizes
the average default spreads of many CDS spreads as well as dollar denominated bonds for
each ratings group.
- Beta
Beta measures the relative riskiness of an investment compared to the average risk of the
market. For instance, a beta of 1.5 indicates that the investment carries 1.5 times more risk
than an average stock invested in the market. Hence, if the stock market increases by 1%, it is
expected that the price of the investment will increase by 1.5%. Beta is generally calculated
according to two methods, the regression and bottom-up method.
First, a standard measure is to regress the stock returns (Rj) – against market returns (Rm).
The slope of the regression corresponds to the beta of the stock and measures the riskiness of
the stock. The statistical way of computing the beta has an initial high standard error.
Furthermore, it reflects the firm’s business mix and the average financial leverage over the
period of regression and not the current mix or current leverage. The beta gives a statistical
result and could diversify as it depends on the period it has been measured. Also, it is
important to know against which index it has been regressed and which index data is used, the

Page 13
weekly, monthly or quarterly index data. Regression beta is not accurate as it is just an
statistical instrument.
According to Damadoran the bottom-up Beta is a much better method of measuring a
company’s beta. Damadoran believes that investors should stop thinking of beta as just a
single number. Instead, he encourages everyone to see the overall picture in which the
business operates, and suggests considering more in macro terms. In order to estimate the beta
pursuant to the bottom-up method, Damodaran suggest understanding first of all the kind of
industry the company operates in. For instance the more discretionary the product or service,
the higher the beta. Secondly, it is important to look at the operating leverage of the business.
The higher the proportion of your cost consists of fixed costs, the higher the company’s beta.
Thirdly, investors should look into the financial leverage of the company. Highly indebted
companies will have a higher beta as it becomes more risky to operate.
The first step of the bottom-up beta is to find the industry or industries that your firm
operates in. The second step is to find the beta of all publicly traded firms in the same industry
to estimate the average beta. Furthermore, unlever the beta by using the average debt to equity
ratio for the industry.
Equation 2-15 Unlevered Beta
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑒𝑡𝑎 𝑎𝑐𝑟𝑜𝑠𝑠 𝑝𝑢𝑏𝑙𝑖𝑐𝑙𝑦 𝑡𝑟𝑎𝑑𝑒𝑑 𝑓𝑖𝑟𝑚𝑠
(1 + (1 − 𝑇)(𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐷
𝐸
𝑟𝑎𝑡𝑖𝑜 𝑎𝑐𝑟𝑜𝑠𝑠 𝑓𝑖𝑟𝑚𝑠)
The third step is to estimate the value of each business in order to calculate the weight of
each business. It is also possible to use the revenue or operating earnings for measuring the
weights. The fourth step is to compute the unlevered beta for the company by multiplying the
betas in step two with the weights in step 3. Finally compute the levering beta for the firm by
using the market debt to equity ratio of the firm.
Equation 2-16 Levered Beta
𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 =
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎
(1 + (1 − 𝑇)(𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐷
𝐸
𝑟𝑎𝑡𝑖𝑜 𝑎𝑐𝑟𝑜𝑠𝑠 𝑓𝑖𝑟𝑚𝑠)
- Market Risk Premium
The market risk premium is the premium investors charge for investing in average equity.
Investors would demand additional amount over and above the risk-free asset in order to hold
the risky asset rather than the risk-free asset. Thus it is the minimum willingness to accept
compensation for the risk.
There are two basic ways to calculate the market risk premium. On the one hand, investors
will estimate the risk premium by looking backwards to calculate how much it has been made

in the past. On the other hand, dynamic forward looking risk premium, investors estimate the
risk premium through looking forwards.
Many people use the historical risk premium approach since it is simple. According to
Damodaran, the historical risk premium approach is the actual returns earned on stocks over a
long time period estimated and compared to actual returns earned on a default-free security
(usually government security). To calculate the historical risk premium, it is initially
important to define the time period. The longer the time period, the lower the standard error of
the risk premium. Secondly, it is important to be consistent with the choice of risk free
security. Thirdly, choose to calculate either the arithmetic or geometric average. The
arithmetic is the simple mean of the series of annual returns whereas the geometric is the
compounded return.
As the historical risk premium is backwards looking, it assumes that everything reverts
back to historic norms. Also, many equity markets do not have as much information available
as the United States. The historical risk premium of countries with limited historical data
would reflect shorter time period but this will result in higher standard error of risk premium.
The forward looking risk premium estimates the expected rate of return on stocks by
computing an internal rate of return based on the assumption that stocks are correctly priced
in the aggregate.16 In order to measure the market risk premium the risk-free rate must be
deducted from the IRR. The main advantage of the forward looking risk premium is the fact
that it could be updated anytime and it presents the expected future risk premium.
Regarding the emerging market countries, many investors believe that they carry an
additional risk. Therefore, the default spread on the bond of the emerging market country will
attached to the risk premium calculated for the developed market. Another method is the
adjusted for equity risk. It is to estimate the volatility of emerging market stock index to its
bond market in order to scale up the additional risk. The volatility is the standard deviation of
the emerging market equity index divided by standard deviation of dollar denominated bond
issued by the EM country. Equation 2-17 on page 14 presents the adjusted equity for risk.
Equation 2-17 Adjusted equity for risk
𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐸(ℛ𝓂) 𝑑𝑒𝑣 + 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑆𝑝𝑟𝑒𝑎𝑑 ∗
𝜎 𝐸𝑀 𝑠𝑡𝑜𝑐𝑘 𝑚𝑎𝑟𝑘𝑒𝑡
𝜎 𝐸𝑀 𝑏𝑜𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡
where,
𝑬(𝓡𝓶) 𝒅𝒆𝒗= Risk premium developed market
An appropriate market risk premium must be deduced with reference to where: the
company is based, or the geography/country where is derives most of its revenues. Therefore,
16
Damodaran, A, “Risk premiums: Looking backwards and forwards”, Stern School of Business PowerPoint: 1-29

Page 15
the country risk premium can be estimated by weighted average of the country risk premiums
of the countries wherein the company operates.
2.1.2.4 Weighted Average
Finally, subsequent to calculating the cost of debt and cost of equity, it is important to
compute the cost of capital of the firm. In order to make that estimation, the weights of equity
and debt will be calculated. Those weights should reflect the market value weights since the
market determines what it will cost you to buy the company in the market today.
Equation 2-18 Market Value of Equity
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 ∗ 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒
Damodaran (PPT) recommends using the yield-to-maturity formula and replacing some of
the independent variables for the market value of debt.
Equation 2-19 Market Value of Debt
Face value of bond = book value of debt
Coupon rate = interest expense
Maturity = Average maturity of debt
Market interest rate = Pre-tax cost of debt
It is now possible to measure the Weighted Average for both equity and debt, and as a
result compute the WACC.
Equation 2-20 Weighted Average of Debt
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
Equation 2-21 Weighted Average of Equity
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
2.2 ACCOUNTING OR BOOK VALUATION
The value of an asset is the present value of the expected cash flow the asset will generate.
When valuing a business, it can be said that the value of the firm is the expected cash flow of
all assets – that is owned by the firm – discounted by the appropriate discount rate. However
there is a main difference between valuing a group of individual assets and valuing a business.
“A business is an entity with an on-going concern that consists of existing assets that it owns
and assets in which it is expected to invest.” The former is called the assets in place and the
latter is called growth assets. In a going concern valuation, “the valuation is computed for
current investments and expected future investments and their profitability.” In the asset based
valuation, “the value of each asset owned by the firm will be separately measured and added
together to come to the value of the business.“
The accounting valuation consists of the book value of the assets and equity on a balance
sheet. The book value is a measure of the value of going concern. There is a general

consensus that the income statement provides a realistic view of firm earnings and the balance
sheet presents’ fair and true value of the assets and equity in the firm. Investors belief that
when the price of a stock is below the book value, the stock is undervalued and vice versa.
The question is whether the book value could be a good measure to show a true value of the
business. The book value of firms with large fixed assets, low potential growth assets and
excess returns would be a reasonable measure of the value of the firm. However, firms with
significant growth opportunities in business where they can create excess returns, the book
value measurement would deliver different results from the true value.
Book Value Using Residual Income Model
Most of the earnings based models that have been developed in recent years are built on
combination of book values and expected future earnings. A residual income model can be
derived from a simple dividend discount model. To begin with, the expected dividend
payments will be substituted by the book value of equity (BV of equity). As it can be seen
from Equation 2-23 below, the BV of equity is equal to previous year’s BV of equity plus
current year net income deducted by the dividend payments. Finally, pursuant to Equation
2-24 below, the value of equity is equal to the current book value of equity and the sum of
present value of excess returns to shareholders.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = ∑
𝐸(𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠𝑡)
(1 + 𝑘 𝑒) 𝑡
𝑡=∞
𝑡=1
Equation 2-23 Book Value of Equity
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑡 = 𝐵𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑡−1 + 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑡 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦0 = 𝐵𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦0 +
∑ ( 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑡 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑡 ∗ 𝐵𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑡−1)𝑡=∞
𝑡=1
(1 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑡)𝑡
2.3 RELATIVE VALUATION
In relative valuation, the value of an asset is compared to the values assessed by the market
for similar or comparable assets. In order to value and compare the assets using the relative
valuation, three essential steps must be considered. Initially, analyst must identify comparable
assets and obtain market values for these assets. Subsequently, the market price will be scaled
to a common variable to generate standardized prices that are comparable as it is incorrect to
compare absolute prices. Thirdly, the differences should be adjusted when comparing their
standardized values.
Even though it is a challenge to compare assets with different characteristics, relative
valuation is a preferred method among analysts. Relative valuation is first of all a great sales

Page 17
instrument since it is a comparison among assets in the market. Secondly, it is easier to defend
a relative valuation than intrinsic valuation due to the former being more implicit. In addition,
relative valuation is an assumption based on market’s perspective, in contrast to intrinsic
valuation which is only an individual’s assumption.
In order to compare the values of firms or equities in the market, we need to standardize
the values in some way by scaling them to a common variable. This part will demonstrate the
three well-known multiples used in the market. Damodaran (2006) describes that “values can
be standardized relative to the earnings firms generate, to the book values or replacement
values of the firms themselves, to the revenues that firms generate or to measures that are
specific to firms in a sector.
2.3.1 Price/ Earnings ratio
The first multiple valuation is the earnings that asset generates. When buying a stock, it is
common to look at the price paid as multiple of the earnings per share generated by the
company which is also called the price/earnings ratio. When buying a business multiple of
operating income or the earnings before interest, taxes, depreciation and amortization
EBITDA.
Both the numerator and denominator in the equation consist of an equity value.
Nevertheless, it is the denominator that plays a vital role in this equation. To begin with, the
most recent fiscal year can be considered for the earnings which is also well-known as the
current PE. Furthermore, it is possible to measure the average earnings per share for the last
four quarters, also known as the trailing PE or calculate the average for the future four
quarters, also known as the future PE. Nevertheless, for a company to have a P/E ratio, the
earnings have to be positive.
Equation 2-25 PE-Ratio
𝑃𝑟𝑖𝑐𝑒 /𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 =
𝐷𝑃𝑆1
𝑟 − 𝑔 𝑛
When dividing both sides by Earnings per share, it is clear that fundamental variables that
drives the PE ratio are the pay-out ratio, growth-rate and required rate of return. Therefore it
can be said, if other things are held equal, the higher the growth rate the higher the PE ratio or
the higher the dividend pay-out ratio the higher the PE ratio. Besides, if other things are held
equal the higher the risk of a company, the lower the PE ratio.
Equation 2-26 PE-ratio
𝑃𝑟𝑖𝑐𝑒 /𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 =
𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 ∗ (1 + 𝑔 𝑛)
𝑟 − 𝑔 𝑛

Investors will look for companies that are undervalued. Hence, a low PE ratio, with high
expected growth rates, with low risk and with high ROE.
2.3.2 Price/Book value
Although the market generally values equities or businesses, accountants also estimate the
value of the businesses. Investors that invest in equity look at the book value of equity and the
price of equity in the market. When valuing the whole business, investors compare the market
value of the firm and the book value of all assets or capital. Therefore, the price/book value
ratio provides investors with the relationship between the market value of the company and its
book value.
Equation 2-27 Price to Book ratio
𝑃𝑟𝑖𝑐𝑒 /𝐵𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ
When dividing both sides by book value per share, it is clear that the variables that drives
the PB ratio are the cost of equity, growth rate, return-on equity and pay-out ratio.
Equation 2-28 Price to Book Ratio
𝑅𝑂𝐸 ∗ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 ∗ (1 + 𝑔 𝑛)
𝑟 − 𝑔 𝑛
Nevertheless, a high PB ratio will come with high ROE ratio and the fundamental drive of
the PB ratio is the return on equity. Furthermore, companies that are traded at cost of equity
should have roughly an equal market value as well as book value. If the ROE significantly
exceeds the cost of equity, companies value will be traded well above the book value. So
firms that will receive attention from investors are those with low PB ratio and high ROE
(undervalued stock) or high PB ratio and low ROE ratio (overvalued stock) in combination
with a high growth rate and low risk.
2.3.3 Price/Sales ratio
The first-two multiples mentioned before are accounting measures and are determined by
accounting rules and principles. The main advantage of using revenue multiples is the fact
that it becomes far easier to compare firms in different markets, with different accounting
standards. Overall, there are two models: the market value of equity to revenues and
enterprise value to revenues.

Page 19
Equation 2-29 Price-to-Sales Ratio
𝑃𝑟𝑖𝑐𝑒 /𝑆𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
Equation 2-28 above is the revenue multiple that is mainly preferred by equity investors. It
describes the multiple of the company’s share traded compared to its revenue. As it has been
mentioned before, the price of a stock could be measured using a Gordon Growth model.
When both sides of the Gordon Growth model are divided by the revenues, one can clearly
tell you that the main drivers of a stable dividend growth firm are the cost of equity, expected
growth-rate the pay-out ratio and the net profit margin.
Equation 2-30 Price to Sales ratio
𝑃0
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠0
=
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ∗ 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 ∗ (1 + 𝑔 𝑛)
It is generally the case that high net profit margin collaborates with high PS ratios. Where
equities have high net profit margin and high PS ratio, it should be noted that a decrease in net
profit margin will result in a proportionally higher drop in the PS ratio. Besides the drop in PS
ratio, it is likely to occur that the growth rate and the ROE will shrink as well.
Nevertheless, it can be said that the PS ratio in Equation 2-30 above is inconsistent due to
the fact that firm revenues are allocated to the entire firm instead of only equity owners. As a
consequence, to bring it back to a consistent model, the market value of equity will be
substituted by the market value of the firm. Similarly, we arrive at the second model of PS
ratio which is the enterprise value to revenues – Equation 2-31 below.
Equation 2-31 Price to Sales Ratio
𝑃𝑟𝑖𝑐𝑒 /𝑆𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒
3 VALUATION IN EMERGING MARKETS
The financial markets in emerging countries are rapidly growing and investors around the
globe have access to more markets. Emerging Markets (henceforth EM) – that have
substantial growth rates – significantly attract the attention of global investors. Furthermore
the growth of the number of cross-border M&A-activities has increased the number of
valuations of emerging market firms (Damodaran, 2009). Also, it is interesting to see that
more and more EM firms have been listed in western countries, such as AliBaba which is
listed at the New York Stock exchange. Therefore, valuation of emerging market equities has
become more interesting and more demanding than ever before.
Although corporate finance experts and scholars have a good understanding of valuing
companies in developed economies, there is still a continued discussion about valuing EM

Chapter: Valuation In Emerging Markets Sep-15
companies. It is generally accepted that models used in developed countries will not be
appropriate to use when projecting the value of EM firms. This part describes the history of
EMs, characters of EMs firms and the limitations of valuation models in EMs. Finally, the
incorporation of the risk parameters of EMs into the valuation model is presented.
3.1 HISTORY OF EMERGING MARKETS
The term emerging markets was first used by Antoine van Agtmael, an economist in the
World Bank, at the end of 1980s, to refer to rapidly growing economies with rapid
industrialization’’ (Van Agtmael, 2007). EMs is countries which are in a transition from
developing to developed markets.
BRICS – abbreviation for Brazil, Russia, India, China and South Africa – are the most
important emerging countries. It is speculated that by 2050 the economies of these countries
would be wealthier than the current major (developed) economies. MINT countries – also
referred to Mexico, Indonesia, Nigeria and Turkey – are well-known for their large, young
and expanding population with dynamic economic development.
The total population of BRICS and MINT countries represents almost 61% of the total
world population or 3.6 billion people. In the last decade, the average annual inflation rate for
BRICS- and MINT-countries was 6.5% and 8.3% respectively. The unemployment rate has
substantially decreased with 14.4% from 2002 to 2012 for BRICS simultaneously a shrink of
6.3% for the MINT-countries. Moreover, the average growth rate of GDP for BRICS and
MINT, between 2002 and 2012, was approximately 5.9% and 5.5% correspondingly. Also,
between 2001 and 2012, ‘’FDI to BRICS and MINT increased by 349% from US$113.6
billion to US$510.4 billion and BRICS only contributed 19% to global GDP in 2011’’(Uduak,
2014; World Bank, 2013).
3.2 CHARACTERISTICS OF EMERGING MARKET FIRMS
1. Currency Volatility
EM firms have significant currency volatility, although in some EM countries the
exchange rate is pegged.
2. Country Risk
EM companies have substantial growth rates associated with some macroeconomic risk
such as economic crisis or political collapse.
3. Unreliable Market Measures
It is difficult to measure the market data – such as cost of debt and equity – since EM
companies prefer borrowing from the bank over borrowing from capital markets.

Page 21
4. Information Gaps and Accounting Differences
Due to less disclosure requirements and accounting differences in EM countries, it is
difficult to compare developed companies to emerging companies. According to Arthur Levitt
– former chair of the U.S. Securities and Exchange Commission (SEC) – “the success of
capital markets is directly dependent on the quality of the accounting and disclosure
system.”17
Therefore, the level of accounting disclosures is a significant determinant in
portfolio equity flow and bond flow to EMs. (Chipalkatti, LE, and Rishi, 2007). Mishari M.
Alfaraih, Faisal S. Alanezi (2011) demonstrates that voluntary disclosure is positively
correlated to firm’s equity valuation on Kuwait Stock Exchange. Also, firms in African
countries adapting the IFRS – rather than the local GAAP – presents significantly higher
returns. Another consequence of IFRS adoption is the fact that it lowers the earnings
management of firms. Hence, better and fairer views of the firm’s financial statements are
presented. In essence, due to good disclosures and value relevance of financial information
EM companies are able to attract more capital at lower cost from developed countries.
5. Corporate Governance
In EM countries companies used to be family-owned businesses. After the companies have
been listed on the stock exchange, the families remain to have a significant impact on the
company since the vast majority of the shares are still owned by them. After big scandals like
Enron, Worldcom and Parmalat, corporate governance has become more important than ever
before.
“A good corporate governance should make firms more accountable and easier to monitor
by shareholders and outsiders. This leads to better or more efficient investment decisions and
eventually to higher corporate value.”18
Morey, Gottesman, Baker, and Godridge (2011) have
completed a research as to whether good corporate governance increases the value of firms in
21 emerging market countries using data from AllianceBernstein19
. Accordingly, there is a
robust association between corporate governance and valuation of a firm. Cheung, Stouraitis,
and Tan (2011) demonstrate similar results for the Asian market however they have also
included corporations with family ownership. Similarly, Li, Chen, and French (2012) believe
that when Russian firms improve their liquidity it positively impact the level of transparency
17 Mishari M. Alfaraih, Faisal S. Alanezi, “Does voluntary disclosure level affect the value relevance of accounting information?”,
Accounting and Taxation Volume3, 2011: p 65-84
18 Yan-Leung Cheung, Aris Stouraitis, and Weiqiang Tan, ‘’Corporate Governance, Investment, and Firm Valuation in Asian Emerging
Markets’’, Journal of International Financial Management & Accounting 22:3, 2011: p 246-273
19 AllianceBernstein today manages over nine billion dollars in emerging market equity assets

Chapter: Valuation In Emerging Markets Sep-15
and disclosures that results in an increase in a firm value. 20
The firm-level governance in
countries – with lower country risk – is more developed. (Godridge, 2011)
In essence, the corporate governance of EM firms are less developed compared to
developed market firms.
3.3 LIMITATIONS IN EMERGING MARKET FIRMS
1. Currency Mismatches
When it is difficult to project the riskfree rate and other risk measures in the local currency,
it is preferable to use another currency. When a risk rate is calculated in another currency, the
cash flows will also be converted in today’s exchange rate to avoid any currency mismatches.
“The mismatch – a low inflation rate built into discount rates (through the use of US dollar
rates) and a high inflation rate built into cash flows (through the use of local currency cash
flows or the current exchange rate) is a recipe for over valuation.” (Damadoran, 2009)
2. Miscounting and Double Counting Country Risk
Analysts that convert the riskfree rate and cashflows into a developed market currency
believe that the country risk should go away. However this assumption is incorrect and
therefore will result in overvaluation. Also, many analysts should adjust either the cashflow or
riskfree rate to comprise the country risk.
Since Beta is seen as a good measure for firm-specific risk, many analysts believe that it is
also sufficient to reflect the country risk. Generally, they will argue that higher risk countries
will have a higher beta. Nevertheless, it is not easy to reflect the country risk in Beta. In fact,
the beta is regressed against the local index and hence the beta for country risk should be 1.
3. Risk Parameters
For the cost of equity the Beta will be regressed against a (foreign) trustworthy index, in
which the firm has been listed. For cost of debt, due to the lack of market-traded corporate
bond, analysts use the book interest rate of company.
Equation 3-1 Book Interest rate
𝐵𝑜𝑜𝑘 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
However the book interest rate for emerging countries is twice as risky as developed
countries. First, the book interest might be very volatile especially if a firm borrows from the
foreign market hence it will have high fluctuation. Secondly, the majority of debt in emerging
20 Wei-Xuan Li, Clara Chia-Sheng Chen, Joseph J. French, “The relationship between liquidity, corporate governance and firm
valuation: Evidence from Russia”, Elsevier Emerging Markets Review, 2012: p 465-477

Page 23
market is short term therefore the cost will be biased as the cost of short term loans are lower
than long term loans.
4. Incorporation Effect
Analysts focus too much on where the company is located rather than where it does
business. For instance, firms – incorporated in an EM country – that generate 80% of their
revenue in developed markets are less exposed to the EM country. However, when calculating
the cost of equity using the EM country risk on top of it will undervalue firms that are less
exposed to EM countries and overvalue firms that are reliable on the EM country.
5. Corporate Governance Mood Swings
Analysts ignore the poor corporate governance in EM firms when the economy is doing
well and consider the risk when the economy is performing poor. It is possible to apply a
fixed discount rate to compensate the poor corporate governance, however it will not reflect
any changes in corporate governance rules in the market.
3.4 INTEGRATING THE LIMITATIONS
This part describes how the corresponding parameters that have been mentioned in the
previous paragraphs can be incorporated in valuation using the DCF model. Although the
input of the DCF are exactly the same for developed and emerging markets, it is a challenge
to integrate risk and limitations of emerging market firms.
A Currency Consistency
Regardless of using local currency valuation, foreign currency valuation or real valuation,
it is vital to remain consistent throughout the valuation process. In case of applying local
currency valuation, the discount rate will either be estimated in the local currency or in the
foreign currency and converted into local currency. Similarly, the cash flow, the growth rate
and expected inflation that are associated in the valuation will also be computed in the local
currency. When it is decided to apply the foreign currency valuation, the riskfree rate
including a consistent equity risk premium are estimated in foreign currency. The cash flows
incorporated with foreign currency valuation are projected in foreign currency, or,
alternatively the cash flows are projected in the local currency and converted into foreign
currency, using expected exchange rates.
Consistency in Country Risk
Valuing an emerging market firm involves country risk measurement– the risk premium
for a particular emerging market – and determination of the firm’s exposure to this country
risk. The country risk premium is calculated using (a) the “default spread for bonds issued by

Chapter: Valuation In The Turkish Market And Review Of Related Literature Sep-15
the emerging market government, (b) the volatility of the emerging market, relative to the US
market and (c) a composite measure that scales up the bond default spread by the relative
volatility of the equity market (relative to the government bond).” Damadoran (2009)
After calculating the country risk, it is important to decide how substantially a company is
exposed to the country risk. Damodaran (2009) suggests using either the Beta or the Lambda
approach. As the Beta approach is elaborated in the previous chapter, this part demonstrates
the lambda approach.
Equation 3-2 Lambda
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑅𝑓 + 𝛽 (𝑀𝑎𝑡𝑢𝑟𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚) + 𝜆 (𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚)
Equation 3-2 above shows that Lambda converts the single-factor model to a two-factor
model that computes a firm’s exposure to the country risk premium. It is a general consensus
that different companies have different exposures to country risk. The level of exposure is
affected by at least three factors. First, it depends on the proportion of revenues of a firm
generated from the country in question. For instance a company that generates 80% of its
revenue in the country in question has a higher exposure than a company that generates 20%
of its revenue. Second, it is possible that a company does not obtain any revenue in the
country in question but its production facilities are in that country. Third, a company reduces
the exposure to country risk as a consequence of buying insurance such derivatives.
The simplest measure of lambda – refer to Equation 3-3 below– is the revenue measure, as
it is easier to assemble this data. The second measure is the regression of the company’s stock
prices against the country’s bond prices.
Equation 3-3 Lambda Revenue Measure
𝐿𝑎𝑚𝑏𝑑𝑎𝑗 =
% 𝑜𝑓 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑖𝑛 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑐𝑜𝑚𝑝𝑎𝑛𝑦
% 𝑜𝑓 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑖𝑛 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡
Equation 3-4 Lambda Regression
𝑅𝑒𝑡𝑢𝑟𝑛 𝑠𝑡𝑜𝑐𝑘 = 𝑎 + 𝜆 𝑅𝑒𝑡𝑢𝑟𝑛 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑏𝑜𝑛𝑑
4 VALUATION IN THE TURKISH MARKET AND REVIEW OF
RELATED LITERATURE
Since the early 1980s, foreign investment in Turkey has gradually increased due to the fact
that government policies implemented a more outward-oriented export-led development
strategy. The large and young growing Turkish population, with substantially increasing
income was one of the motives to invest in the country. Energy, transportation, financial
services, telecommunication, tourism and retailing were substantially expanding sectors in
which multinational investors could gain yield. Pursuant to Tatoglu and Glaister (1998),

Page 25
Turkey eliminated its autarkic inward-oriented economy and has become one of the region’s
most liberal investment regimes.
Following the liberalizing of the Turkish economy beginning in the 2000s, the number of
Mergers and Acquisitions (M&A) has considerably increased. Transactions that barely
reached a volume of US$ 1 billion until 200221
have significantly improved, in 2014, to total
M&A deal volume of around US$21 billion with 236 transactions. It was privatization that
had made a substantial impact on the total deal volume, “while the vitality in the middle
market was the main driver of the overall M&A activity.” Deloitte (2014) Not to forget, the
one-party rule that generated a political stability and consistent growth performance have
attracted foreign investors’ interest in the country.
Apart from the political stability, the Turkish Capital Market Board (hereafter CMB)
introduced the Corporate Governance Principles in 2003. Well-established Corporate
Governance leads generally to “prevention of outflow of domestic funds, an increase in the
competitive power of the economy and capital markets”22
. Francis, Hasan and Song (2013)
found that firm-level corporate governance positively affects firms' access to financing, as
measured by the growth rate in firms' leverage. Gurbuz, Aybars and Kutlu (2010) found that
good corporate governance practices enhance firms – listed on Istanbul Stock Exchange
Corporate Governance Index (hereafter ISE CGI) – financial performance. Nevertheless, Icke
B., Icke M. and Ayturk (2011) and Mugaloglu and Erdag (2013) describe that buying only
firms listed on the extended ISE CGI cannot generate abnormal returns because of their low
risk level.
As a consequence of development of the Corporate Governance principles, from 2015
onwards, “Turkish listed firms on the Istanbul Stock Exchange (ISE) are required to adopt
IFRS in preparation and presentation of their financial statements”. Previously, Turkish
companies prepared and reported their financial statements under the local accounting
standards based on historical cost accounting. Suadiye (2012) regressed the market price of
shares, with book value of equity per share and earnings per share – using the suggested
model of Ohlson (1995) – before and after the adoption of IFRS for 139 Turkish listed firms
on the ISE. It appears the value relevance of accounting information improved with the
adoption of IFRS which is consistent with previous literature.
21
Sevket Basev, ‘’Turkish M&A: starting late but going strong’’, International Financial Law Review, April 24 2013,
http://www.iflr.com/Article/3196381/Turkish-M-A-starting-late-but-going-strong.html
22
Gül Okutan Nilsson (2007), “Corporate Governance in Turkey”, European Business Organization Law Review :8, 2007: p 199

Chapter: Valuation In The Turkish Market And Review Of Related Literature Sep-15
In the previous chapter, the myriad valuation models for either firm or equity valuation has
been demonstrated. Generally, residual income method is preferred by academicians in the
accounting field, whereas discounted cash flow technique is the choice in the finance field.
For instance, Brotherson, Eades, Harris and Higgins (2014) found that major investment
banks frequently use the DCF framework for valuing a business. Perek and Perek (2012) used
a case study with data from nine Turkish companies and found that Residual Income model
results in lower company valuation compared with the DCF model. The higher value of the
DCF model could be due the fact that Turkish companies have significantly invested in fixed
assets – as a consequence of political stability – that generated high depreciation expenses.
Aksu and Onder (2003) found both size and book-to-market effects to be significant on
stock returns of ISE, but the size effect has a higher explanatory power. Nevertheless,
research completed by Anandarajan, Hasan, Isik and McCarthy (2006) indicates that both
earnings and book value are important predictors of equity valuation. In Turkey, earnings
appear to be declining in importance over time. Book value adjusted for inflation has a
stronger association with equity values. This is explained by Thies and Sturrock (1987) who
show that historical cost accounting overstates profitability during a period of rising prices,
and misrepresents the relative financial strengths of firms. Earnings and inflation-adjusted
book values combined explain almost 75% of the variation in equity prices in Turkey.
(Anandarajan, Hasan, Isik and McCarthy, 2006)
Markowitz (1952) developed the CAPM model but Pettengil et al (1995) tested the beta for
bearish and bullish market and presented that there is a conditional relationship between beta
and return. Karacabey and Karatepe (2004) applied a similar test to the Istanbul Stock
Exchange for the period between 1990 and 2000 and found also a conditional relationship.
For the period between 2003 and 2011, Bilgin and Basti (2014) completed a similar test for
ISE. Since the risk-return relationship for bear and bull market is not symmetric, they believe
that neither the standard CAPM nor its conditional version can perfectly estimate the
riskreturn relationship in the ISE. However, the conditional version seems to be a much more
promising alternative to the standard CAPM as a simple method for stock valuation. (Bilgin
and Basti, 2014)
Turkey is attracting the attention of investors for many reasons. To begin with, it has a
booming economy in which it tripled its GDP from USD 231 billion in 2002 to USD 800
billion in 2014. Moreover, Turkey is expected to become one of the fast growing economies
among the OECD members. Turkey’s demographic of young and well-educated population
establishes promises of accelerating the growth rate of the country’s GDP. Furthermore, it is

Page 27
seen as a “natural bridge between both East-West and North-South axes, thus creating an
efficient and cost-effective outlet to major markets.” Besides, its central located position is
easy accessible to 1.5 billion customers in Europe, Eurasia, the Middle East and North Africa.
Not to forget, Turkey has an immense large domestic market whose consumption level
considerably increased in the last decade. A good example is the airline industry: the airline
passengers increased up from 33 million in 2002 to 166,5 million airline passengers in 2014.
(TurkStat)
In essence, the Turkish market has been in a developing stage for the last decade, there is
plenty of research available that is applied to the Istanbul Stock Exchange. Especially after the
financial crisis of 2008, Turkey has become an attractive market to invest by western financial
institutions since it has delivered significant growth rates. Therefore it is interesting to see
how analyst value emerging market firms in particular Turkey.
The goal of this study is to contribute to the understanding of valuing a Turkish company
by analysing the different approaches of investors in the Turkish market.

Chapter: Research Methodology Sep-15
5 RESEARCH METHODOLOGY
5.1 RESEARCH METHODOLOGY
Valuation is an interesting topic that does not have a single reality. It is very subjective and
it can be more of an art than science. Since there is no single reality, it is important to see how
different experts value emerging market firms and especially Turkish firms. It is important to
think about using the kind of data and technique for collecting the data. In order to answer the
research question above, a qualitative research method was applied using two different
methods of collecting data.
5.1.1 Research Philosophy
To begin with, the research philosophy is about the way in which you view the world. It is
a belief about the way in which data about valuation of firms in Turkey should be gathered,
analysed and used. According to Johnson and Clark ( 2006), ‘’the important issue is not so
much whether the research should be philosophically informed, but how well you are able to
upon the philosophical choices and defend them in relation to the alternatives we could have
adopted’’. The social world of business and management is far too complex to lend itself to
theorising by definite ‘laws’ in the same way as the physical sciences. Insights into this
complex world are lost if such complexity is reduced entirely to a series of law-like
generalisations. The research philosophy applied is interpretivism. An interpretivism research
philosophy is “associated with the philosophical position of idealism, and is used to group
together diverse approaches, including social constructionism, phenomenology and
hermeneutics; approaches that reject the objectivist view that meaning resides within the
world independently of consciousness” (Collins, 2010, p.38).
5.1.2 Research Approach
The extent to which you are clear about the theory at the beginning of your research raises
an important question concerning the design of your research project. Easterby-Smith et al.
(2008) believes that choosing a research approach is vital for three reasons. Initially, it
enables you to take more informed decision about your research design. Secondly, it will help
you to think about those research strategies and choices that will work for you. Finally,
Easterby-Smith et al. (2008) argue that knowledge of the different research traditions enables
you to adapt your research design to cater for constraints.
Inductive approach was applied in this research, wherein the theory followed data. The
researcher started with a ‘bottom-up’ approach, that starts by collecting data on the topic of
interest and the main purpose is to build on existing theories, rather than to test existing

Page 29
theories (Myers, 2013). Furthermore it is crucial to understand what humans interpret rather to
know the cause-effect link to be made between variables. Establishing such an understanding
is the strength of an inductive approach.
5.1.3 Research Design
Research design is a general plan of how you will go about answering the research
question. It is a process wherein the researcher explains the choice of a particular source for
collecting data, the constraints of the data process and the ethical issues that are associated
with the process. In other words, the researcher defines the research strategies, research
choices and time horizons.
5.1.3.1 Research Purpose
Generally, the research purpose of a clearly defined research question is self-declared.
However, it is possible that a research question can have multiple-purposes, indeed Robson
(2002) indicates that the purpose might change over time. Overall, there are three different
research purposes: exploratory studies, descriptive studies and explanatory studies.
This research adapts two of the three principles of conducting exploratory research: a
search of the literature and interviewing ‘experts’ in the subjects. Furthermore, Adams and
Schvaneldt (1991) argued that exploratory research can be likened to the activities of the
traveller or explorer. The direction would change as matter of fact that new data brings new
insights to the researcher. Adams and Schvaneldt (1991) believe that a change of direction
does not mean absence of the direction to the enquiry but the focus on the research question
becomes progressively narrower. Besides this research is an extension of an exploratory study
since it described the valuation method used in the Turkish Market. Hence, the purpose of this
research is a combination of exploratory and descriptive study.
5.1.3.2 Research Strategy
A research strategy is a guidance of the research questions and objectives. The choice of
research strategy depends on the extent of existing knowledge of the researcher and the
amount of time and resources that are available. Survey strategy was applied since expert
interview was completed for this research. This strategy allowed the researcher to collect
qualitative data that was used to explain the reason for using particular valuation method in
Turkish market. The only disadvantage was that progress was delayed as the data collection
was depended on others.
5.1.3.3 Research Choice
The results of the research will be affected by the techniques and procedures used. As a
consequence of this inevitable relationship, the researcher required to choose prudently the

data collection method. Saunders, Lewis, & Thornhill (2009) describe qualitative data as
synonym for any data collection technique (such as an interview) or data analysis procedure
(such as categorising data) that generates or use non-numerical data. When more than one
data collection is used for answering the research question, it refers to a multi-method. A
multi-method enables to underpin a more powerful answer of the research question, since it
allows the researcher to better evaluate the extent of the research findings and inferences
made of them. Nevertheless, a multi-method qualitative study was applied to this research as
interview was conducted among experts in the field of valuation as well as Turkish firm’s
analyst reports were analysed.
5.1.3.4 Time-Horizons
Cross-sectional studies are usually aligned with survey strategy. Easerby-Smith et al
(2008) and Robson (2002) cited in Saunders (2009) the expert-survey strategy applied in this
research embraces the experience and knowledge of valuation experts who are employed in
different countries at organization and different level. Besides, the valuation analysis report
was composed by different organizations. Therefore, a cross-sectional study was applied in
order to answer the research question.
5.1.4 Data Collection Method
In order to answer the research question, there are generally two kinds of data collection
methods: 1. Secondary data collection and 2. Primary data collection. A combination of
secondary and primary data collection was deployed in this research. Although the researcher
mainly relied on the primary data in answering the question, the secondary data’s purpose was
to strengthen the findings of the primary data.
5.1.4.1 Secondary Data Collection
Secondary data include both raw data – quantitative and/or qualitative– and published
summaries that are primarily used in descriptive research. There are three main sub-groups:
documentary data, survey-based data and multiple-source. According to Ghauri and Grønhaug
(2005) cited in Saunders (2009), the main advantage of using secondary data is saving in
resources such as time and money. However, the data collected would have a different
research purpose than the research question and objective that is practiced in this research.
Consequently, secondary data is only able to answer the question partially.
For this research, the secondary data was mainly composed from Bloomberg terminals,
company reports prepared by specialist in the Turkish market. Also, company interim report
and annual reports were retrieved from the company website. Moreover, academic and
professional journals obtained from Business Source Complete and Science Direct were

Page 31
exploited in order to acquire a deeper insight of the topic. Furthermore, macroeconomic
indicators which were provided by the Worldbank were used to emphasize the characteristics
of emerging markets. Finally, an annual M&A review report published by Deloitte was used
to explore the trends in the Turkish Market.
5.1.4.2 Primary Data Collection
Primary data can be collected through observations, using semi-structured, in-depth and
group interviews and questionnaires. This research used a questionnaire to collect the primary
data. Questionnaire is the most frequently collection method that is associated with the survey
strategy. Saunders (2009)
Pursuant to deVaus (2002), cited in Saunders (2009), questionnaire is used as a technique
of data collection in which each person is asked to respond to the same set of questions in a
predetermined order. Since this research was partly a descriptive study, opinion
questionnaires enabled us to identify and describe the variability in different phenomena.
Although it is an efficient way of collecting responses, it is a challenge to design a good
questionnaire. Consequently, the design of the questionnaire determines the response rate and
the reliability and validity of the data that is collected.
Overall, there are two types of questionnaires: 1. Interviewer-administrated questionnaires
and 2. Self-administrated questionnaires. The former are recorded by the interviewer on the
basis of each answer and it could be either conducted through the telephone ( telephone
questionnaire) or face-to-face (structured interview). The latter are usually completed by the
respondents and are administrated electronically. There are three types of self-administrated
questionnaires:
1. Internet and Intranet mediated questionnaires: conducted via the internet or
intranet.
2. Postal Questionnaire: posted to respondents who return them by post after
completion.
3. Delivery and collection questionnaire: delivered by hand to each respondent and
collected later.
The self-administrated internet questionnaire was practiced in this study because it is the
most effective and efficient method. First of all, considering the characteristics of the
respondents, the internet organized interview was at the respondents’ convenience. Secondly,
the data was administrated at one place and comparisons of the answers from respondents
were easier to make.
5.1.5 Questionnaire Design

The design of the questionnaire was significantly important because questions must be
understood by the respondent in the way intended by the researcher and the answer given by
the respondent must be understood by the researcher in the way intended by the respondent.
To begin with, the researcher explored on existing surveys on emerging market. Pereiro
(2001) organized a survey in the Argentinian market to unveil practitioners’ method of
company valuation. Although Pereiro’s research aim differed from this research, it was useful
to read the question structure. This research was seeking for experts’ opinion or experiences
on valuation of Turkish companies, hence open-questions were asked to respondents.
According to Fink (2003) cited in Saunders (2009) open questions allow respondents to give
answers in their own way (Fink 2003a)
The questionnaire contained an introduction and 7 open-ended questions. The introduction
mentioned the aim of the questionnaire, emphasized the general instructions about filling the
questionnaire and it was closed with a brief thanks. The 7 questions consisted of two parts:
two questions relating to information about the respondent and five-open-ended questions
targeting to collect insights of the respondents’ knowledge and experience about valuation in
emerging markets and Turkish market:
1. What is your job role?
2. Which of the following best describes the principal industry of your organization?
3. In your opinion, what are the characteristics of Emerging Market companies/
exposures?
4. In your opinion, is there any particularity (process, valuation tools, etc) when
valuing companies listed in emerging markets?
5. What kind of risks should an analyst/investor consider when valuing a Turkish
company?
6. Which valuation model/tool (DCF, Multiples, Residual Income, EVA, etc.) do you
use when valuing a Turkish company? Can you please explain why?
7. What model will become the benchmark for estimating required returns in
emerging markets?
In order to maximize the responds rates, the questions were concise and logically
structured. After considering the feedback of a colleague, schoolmate and tutor, the
questionnaire was designed using MonkeySurvey.com.
5.1.6 Sampling
It is impracticable to survey the entire population, therefore a sample is selected to
represent the population. When selecting the sample, it is important to consider what needs to

Page 33
be figured out, what will be useful, what will have credibility and, the most important, what
can be done within your available resources. Patton (2002) cited in Saunders (2009). Since the
topic of the research was valuation of the Turkish market, the aim was to understand
commonalities within a homogenous group. Therefore the sample size undertaken – just under
10 respondents – was sufficient to obtain in-depth knowledge about the research.
The researcher applied the self-selection sampling and collected data from those who
responded. LinkedIn and E-mail had been the two mediators with which the respondents were
invited to fill-in the online questionnaire. Key terms such as: “Turkish”, “Investment”,
“Analyst”, “M&A”, “DCM” and “ECM” were entered in the search box of LinkedIn and
google. LinkedIn limits the number of messages sending to members that are not friends.
Consequently, the researcher googled analysts who followed and analysed Turkish
companies. Using the E-mail – from the available contact details – the questionnaire sample
included 70 people.
Table 1 Respondents Overview
The below presents an overview of the respondents that were selected for the questionnaire
Responden
t
Country Job Role Working industry
1 Turkey Director, Equity Research Finance & Financial Services
2 Turkey Equity analyst Finance & Financial Services
3 Turkey Equity analyst, Director Finance & Financial Services
4 Turkey Graduate analysts Finance & Financial Services
5 Turkish Head of Turkish Equity Research,
Sell-Side Analyst
Finance & Financial Services
6 UK Investment Manager Finance & Financial Services
7 UK Investment Manager Manufacturing
8 US Investment Banking Analyst Finance & Financial Services
As it can be seen from Table 1 above, the questionnaire was completed by 8 respondents,
hence a response-rate of 11.4%. The job levels of the respondents differ from being a graduate
analyst to a director. Furthermore, one can tell that 62.5%, 25% and 12.5% of the respondents
are employed in Turkey, United Kingdom and United States respectively. Moreover, 87.5%
of the respondents operate in Finance & Financial services and 12.5% in manufacturing
industry.

Chapter: Data Analysis Sep-15
6 DATA ANALYSIS
This chapter delves into the collected data from the questionnaire, and shows similarities
and differences in the thinking patterns of the respondents. The second part of this chapter is
an additional analysis of Turkish companies.
6.1 QUESTIONNAIRE RESULT
6.1.1 The Characteristics of Emerging Market Companies
In your opinion, what are the characteristics of Emerging Market companies/
exposures?
Generally the respondents have a similar opinion about the characteristics of Emerging
Market companies.
To begin with, 75% of the respondents believe that the characteristics of EMs companies
consist of high volatility as well as high beta which correspond to Damadoran (2009).
Respondent 6 believes that EM companies operate in a very versatile environment comparing
to developed countries and are managed by highly skilled professionals. According to
Respondent 1, the high volatility is a result of substantial political risks that is present in the
countries. Respondent 5 believes that the appearance of volatility in EM firms is a
consequence of high systemic risk. Indeed, EM firms are not only prone to political risks but
also macro risks. Therefore riskfree rate and equity-risk premium are usually higher.
Secondly, 62.5% of the respondents suggest that the firms in EM markets have a high
growth rate. Besides, Respondent 2 indicated that businesses are usually local oriented.
Thirdly, FX volatility is available in EMs since firms prefer borrowing in a stable currency
over the local currency which is more expensive according to Respondent 3. This is in align
with Damodaran (2009) and suggest regardless of the fact whether EM countries peg their
currency, the FX-volatility will still remain.
Fourthly, EM firms are significantly controlled by a small number of shareholders. Due
to high ownership of controlling shareholders, respondent 5 claims that the free float is on
average 30%. Besides, Respondent 7 describes that EM firms are generally family owned
with low level of sophistication and limited resources.
Finally, there is a lack of corporate governance and accounting policies in EMs.
Godridge (2011) suggested that the firm-level governance in countries – with lower country
risk – is more developed. According to respondent 5, the corporate governance practices are
not at developed market standards and the firms have a weak disclosure and transparency. A
research completed by Mishari M. Alfaraih, Faisal S. Alanezi (2011) showed that voluntary

Thesis Abdurrahman Ozturk

Recommended

Recommended

More Related Content

What's hot

What's hot (8)

Similar to Thesis Abdurrahman Ozturk

Similar to Thesis Abdurrahman Ozturk (20)

Thesis Abdurrahman Ozturk