MBA 3rd semester FM01 Notes

1. Equity Valuation Methods
Equity valuation methods can be broadly classified into balance
sheet methods, discounted cash flow methods, and relative
valuation methods. Balance sheet methods comprise of book
value, liquidationvalue, and replacement value methods.
Discounted cash flow methods include dividend discount models
and free cash flow models. Lastly, relative valuation methods are
a price to earnings ratios, price to book value ratios, price to
sales ratios etc.
CLASSIFICATION OF EQUITY VALUATION METHODS
Fundamental equity valuation methods are explained in brief
under the following categories.
BALANCE SHEET METHODS / TECHNIQUES
Balance sheet methods are the methods which utilize the balance
sheet information to value a company. These techniques
consider everything for which accounting in the books of
accounts is done.
BOOK VALUE METHOD
In this method, book value as per balance sheet is considered
the value of equity. Book value means the net worth of the
company. Net worth is calculated as follows:
Net Worth = Equity Share capital + Preference Share Capital +
Reserves & Surplus – Miscellaneous Expenditure (as per
B/Sheet) – Accumulated Losses.
LIQUIDATION VALUE METHOD

2. In this method, liquidation value is considered the value of
equity. Liquidation value is the value realized if the firm is
liquidated today.
Liquidation Value = Net Realizable Value of All Assets – Amounts
paid to All Creditors including Preference Shareholders.
REPLACEMENT COST METHOD
Here, the value of equity is the replacement value. It means the
cost that would be incurred to create a duplicate firm is the value
of the firm. It is assumed that the market value and replacement
value will coincide in the long run. The famous ratio by James
Tobin is Tobin q which tends to become 1. Tobin q is the ratio of
market value to replacement cost.
Equity Value = Replacement Cost of Assets – Liabilities.
DISCOUNTED CASH FLOW METHODS / TECHNIQUES
Discounted cash flow methods are based on the fact that present
value all future dividends and the future price represent the
market value of equity.
DIVIDEND DISCOUNT MODEL
This model finds the present value of future dividends of a
company to derive the present market value of equity. There are
various models with different assumptions of a period of
dividends and growth in dividends.
1. Single period Model
Single Period Model, one of the discounted cash
flow models, is an income valuation approach that aims to find
the fair value of a stock/firm using single projected cash flow
value and then discounting it with an appropriate discount rate.
Taking all future streams of cash flow into one single period and
discounting is also referred as “Earnings Capitalisation”.

3. Value of a firm or company = Net Income / Discounting Rate
2. Multi-period Model
Multiple Period Model of Equity
Valuation- dividend discount model, like any other discounted
cash flow model, aims at arriving at the intrinsic/fair value of the
stock. In the multi-period model, we take into account the
dividend stream for infinite years and discount it using
appropriate discount rate to arrive at the fair value; however
assuming the investor has a holding period in mind, the multi-
period model will take that many years into account to arrive the
intrinsic value of the stock.
Formula
Po = D1/ (1+r) + D2/ (1+r) ^2 + D3/ (1+r) ^3 + …… Dn/ (1+r) ^n
Where,
Po = Price of the equity share
D1 = expected dividend 1 year from now
D2 = expected dividend 2 years from now
Dn = expected dividend n years from now
r = expected rate of return (cost of equity)

4. 3. Zero Growth Model
P= Divident/r
P= price , r= required return
4. Constant Growth Model
This model assumes that both the dividend amount and the
stock’s fair value will grow at a constant rate. To put in simple
words, this model assumes that the dividend paid by the
company will grow at a constant percentage.
Gordon growth model, also known as ‘Constant Growth Rate DCF
Model’, has been named after Professor Myron J. Gordon.
Stock Value (p) = D1/ (k-g)
Where, p = Intrinsic value of the stock/equity
k = Investors required rate of return, discount rate
g = Expected growth rate (Note: It should be assumed to be
constant)
D1= Next years expected annual dividend per share
5. Two Stage Growth Model
The two-stage model can be used to value companies where the
first stage has an unstable initial growth rate and there is a stable
growth in the second stage which lasts forever. The first stage
may have a positive, negative, or a volatile growth rate and will

5. last for a finite period while the second stage is assumed to have
a stable growth rate for the rest of the life of the company. In this
model, it is assumed that the dividend paid by a company also
grows in the exact way i.e. in two such stages.
6. H Model
H model is another form of Dividend Discount Model under
Discounted Cash flow (DCF) method which breaks down the cash
flows (dividends) into two phases or stages. It is similar or one
can say a variation of a two-stage model however unlike the
classical tw0- stage model, this model differs in how the growth
rates are defined in the two stages.
In the two-stage model, it is assumed that the first stage goes
through an extraordinary growth phase while the second stage
goes through a constant growth phase.
FREE CASH FLOW MODEL
This model is based on free cash flows of the company. Similar
to above model, it discounts the free future cash flows of the
company to arrive at an enterprise value. To find the value of
equity, value of debt is deducted from enterprise value.
EARNINGS MULTIPLE OR COMPARABLES OR RELATIVE
VALUATION METHODS / TECHNIQUES
Earnings multiple or Relative Valuation methods are also called
comparable methods because they use peers or competitors
value to derive the value of the equity. The importance here is of
deciding which factor to be considered for comparison and
which companies should be considered peers. Following are the
well-known methods used for such comparison.

6. 1. PRICE TO EARNINGS RATIO
The price-earnings ratio (P/E ratio) is the ratio for valuing a
company that measures its current share price relative to its per-
share earnings. The price-earnings ratio is also sometimes
known as the price multiple or the earnings multiple.
The P/E ratio can be calculated as:
Market Value per Share / Earnings per Share
2. PRICE TO BOOK VALUE RATIOS
The price-to-book ratio (P/B Ratio) is a ratio used to compare a
stock's market value to its book value. It is calculated by dividing
the current closing price of the stock by the latest quarter's book
value per share.
Also known as the "price-equity ratio".
Calculated as:
P/B Ratio = Market Price per Share / Book Value per Share
where Book Value per Share = (Total Assets - Total Liabilities) /
Number of shares outstanding
3. PRICE TO SALES RATIO
Price-to-sales ratio is considered a relative valuation measure
because it's only useful when it's compared to the P/S ratio of
other firms. The P/S ratio varies dramatically by industry. For
example, retail companies typically display a much higher P/S
ratio than companies highly involved in research and
development. Therefore, when comparing P/S ratios, make sure
the firms are within the same industry.

7. The price-to-sales ratio helps determine
a stock’s relative valuation. The formula to calculate the P/S ratio
is:
P/S Ratio = Price Per Share / Annual Net Sales Per Share
Economic value added is the incremental difference in the rate of return
over a company's cost of capital. In essence, it is the value generated from
funds invested in a business. If the economic value added measurement
turns out to be negative, this means a business is destroying value on the
funds invested in it. It is essential to review all of the components of this
measurement to see which areas of a business can be adjusted to create a
higher level of economic value added. If the total economic value added
remains negative, the business should be shut down.
To calculate economic value added, determine the difference between the
actual rate of return on assets and the cost of capital, and multiply this
difference by the net investment in the business. Additional details
regarding the calculation are:
 Eliminate any unusual income items from net income that do not relate to
ongoing operational results.
 The net investment in the business should be the net book value of all
fixed assets, assuming that straight-line depreciation is used.
 The expenses for training and R&D should be considered part of the
investment in the business.
 The fair value of leased assets should be included in the investment figure.
 If the calculation is being derived for individual business units, the
allocation of costs to each business unit is likely to involve extensive
arguing, since the outcome will affect the calculation for each business
unit.

8. The formula for economic value added is:
(Net investment) x (Actual return on investment – Percentage cost of
capital)
This calculation yields more reliable results when the targeted
organization has a large asset base. Its results are less certain when a
business has a large proportion of intangible assets.
What is a 'Perpetual Bond'
A perpetual bond is a fixed income security with no maturity date. One
major drawback to these types of bonds is that they are not
redeemable. Given this drawback, the major benefit of them is that
they pay a steady stream of interest payments forever. A perpetual
bond is also known as a "consol" or a "perp".
The formula for the present value of a perpetual bond is simply:
Present value = D / r
Where:
D = periodic coupon payment of the bond
r = discount rate applied to the bond