This document discusses various equity valuation approaches and methods. It begins by outlining the valuation process of understanding the business, forecasting performance, and selecting an appropriate valuation model. It then describes absolute valuation methods like discounted cash flow analysis using free cash flow to the firm (FCFF) or free cash flow to equity (FCFE). Relative valuation methods discussed include comparing price/earnings (P/E), price/book value (P/B), and enterprise value/EBITDA multiples to industry peers. The document also briefly discusses the residual income model and notes factors to consider in choosing the most appropriate valuation model.

1. Equity Valuation
Chetan G. Shah, CFA

2. The Valuation Process…
• Understanding the business: industry structure &
attractiveness, demand-supply & long term prospects,
competitive position and corporate strategies (Porter 5 forces).
• Forecasting company performance: relevant
economic & industry variables, company sales, earnings,
financial position and free cash flows.
• Selecting the appropriate valuation model –
going concern, liquidation, operating & non-operating parts,
intrinsic value and relative valuations. Should be consistent with
the characteristics of the company, ownership perspective
(majority or minority) and appropriate given the availability &
quality of data.
• Making investment decision, e.g. ex ante alpha and
ex post alpha returns.

3. Valuations: Approaches
• Absolute valuations: discounted cash flows
where the cash flows could be dividends, free cash
flow to firm or equity (FCFF or FCFE)
• Relative valuations: P/E (trailing or leading), P/B,
P/S, EV/EBITDA, Replacement value like EV/Ton
for cement & steel businesses. Company multiples
vs. industry peers or some benchmark on like to
like basis.
• Residual income: which is present book value
plus the future stream of residual income which is
net profit less equity charge.

4. Valuation: Absolute
Discounted cash flows:
∞
CFt
Dividends V0 = ∑ FCFE
i =1 (1 + r )
t
n
D P FCFF
V0 = ∑ t t + n n ∞
FCFEt
t =1 (1+ r) (1+ r) ValueEquity = ∑
∞
FCFFt (1 + r )t
ValueFirm = ∑
i =1
∞
Dt i =1 (1 + WACC )t
V0 = ∑
t =1 (1 + r )t
D0 (1 + g ) D ValueEquity = ValueFirm − MarketValueDebt
V0 = = 1
r−g r−g
Gordon Growth
Model

5. Computing FCFF
FCFF = Net income available to common shareholders
Plus: Net non-cash charges (like depreciation, deferred taxes)
Plus: Interest expense x (1-Tax rate)
Less: Investment in fixed capital (FCInv)
Less: Investment in working capital (WCInv)
FCFF = NI + NCC + Int (1 − TaxRate) − FCInv − WCInv
FCFF = CFO + Int (1 − TaxRate) − FCInv
FCFF = EBIT (1 − TaxRate) + Dep − FCInv − WCInv
FCFF = EBITDA(1 − TaxRate) + Dep (TaxRate) − FCInv − WCInv

6. Computing FCFE
Some of ways FCFE is calculated:
FCFE = FCFF − Int (1 − TaxRate) + NetBorrowing
FCFE = NI + NCC − FCInv − WCInv + NetBorrowing
FCFE = CFO − FCInv + NetBorrowing
FCFE = EBIT (1 − TaxRate) + Dep − Int (1 − TaxRate) − FCInv − WCInv + NetBorrowing
FCFE = EBITDA(1 − TaxRate) + Dep (TaxRate) − FCInv − WCInv + NetBorrowing

7. DCF - Illustration using FCFF
Y/E March 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
No of units mn Key assumption 10,000 10,000 18,000 26,000 31,000 36,000 41,000 46,000 51,000 51,000
ASP (Rs / units) Key assumption 4.50 4.50 4.00 3.75 3.50 3.50 3.50 3.50 3.50 3.50
Sales (INR mn) =A4 * A5 45,000 45,000 72,000 97,500 108,500 126,000 143,500 161,000 178,500 178,500
EBIT margins Key assumption 23.5% 23.5% 20.0% 18.0% 18.0% 18.0% 17.0% 16.0% 15.0% 15.0%
Effective tax rate Key assumption 18.1% 18.1% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0% 25.0%
NCC / sales Key assumption 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 4.8% 4.5% 4.0% 4.0%
WC Inv / Sales Key assumption -1.3% -1.5% -1.5% -1.5% -1.5% -1.0% -1.0% -1.0% -1.0% -1.0%
EBIT = A6 * A9 10,575 10,575 14,400 17,550 19,530 22,680 24,395 25,760 26,775 26,775
EBIT * (1-tax rate) = A14 * (1 - A10) 11,410 8,665 10,800 13,163 14,648 17,010 18,296 19,320 20,081 20,081
NCC = A6 * A11 2,250 2,250 3,600 4,875 5,425 6,300 6,816 7,245 7,140 7,140
WCInv = A6 * A12 (604) (694) (1,080) (1,463) (1,628) (1,260) (1,435) (1,610) (1,785) (1,785)
FCInv Forecasted (5,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (5,000)
FCFF =A15 + A16 + A17 + A18 8,056 220 3,320 6,575 8,445 12,050 13,678 14,955 15,436 20,436
WACC = A33 * A29 + A34 * A26 11.82%
Risk free return Key assumption 7.50%
Beta (Estimated) Key assumption 1.20 Free Cash Flow to Firm
Risk premium Key assumption 8.00%
Discount rate for Equity = A23 + A24 * A25 17.10% FCFF =
Yield on 10yr Corp. bond Key assumption 10.000%
Tax rate Key assumption 18.00%
EBIT*(1-Tax rate)
Discount rate for debt =A27 * (1 - A28)
Estimated debt in 2011 Forecasted
8.20%
61,250
+ Non Cash Charge (NCC)
Estimated equity in 2011 Forecasted 41,942 – Investment in Working Capital (WCInv)
Total capital employed Forecasted 103,192
Weight of Debt =A30 / A32 59.36% – Investment in Fixed Assets (FCInv)
Weight of Equity =A31 / A32 40.64%
Total weight 100.00%
Continued on next page

8. DCF - Illustration using FCFF
FCFF =A15 + A16 + A17 + A18 8,056 220 3,320 6,575 8,445 12,050 13,678 14,955 15,436 20,436
WACC = A33 * A29 + A34 * A26 11.82%
Risk free return Key assumption 7.50%
Beta (Estimated) Key assumption 1.20
Risk premium Key assumption 8.00%
Discount rate for Equity = A23 + A24 * A25 17.10%
Yield on 10yr Corp. bond Key assumption 10.000%
Tax rate Key assumption 18.00%
Discount rate for debt =A27 * (1 - A28) 8.20% Value of Equity=
Estimated debt in 2011 Forecasted 61,250
Estimated equity in 2011 Forecasted 41,942 Value of Firm
Total capital employed Forecasted 103,192
Weight of Debt =A30 / A32 59.36% - Value of Debt
Weight of Equity =A31 / A32 40.64%
Total weight 100.00%
Present value of FCFF =NPV(C21, D19:M19) 49,672
Terminal Value (2020) =M19 / A21 172,934
Present value of TV =A38 / (1+A21)^(1/10) 56,596
Enterprise Value =A37+A39 106,269
Debt 61,250
Equity value (INR mn) =A40 - A41 45,019
No of shares (mn) 472.45
Price =A42 / A43 95.29
Spreadsheet models are very flexible in the sense that they provide an ability to value
any pattern of expected free cash flow.

9. Valuation: Relative
1) Based on Methods of Comparables…
involves using a price multiple to evaluate whether an asset is relatively fairly valued, undervalued
or overvalued when compared to a benchmark value of the multiple.
Name M-CAP EV/EBITDA P/E
Year INR mn 1FY 2FY 3FY 1FY 2FY 3FY
X1 43,066 5.5 4.5 4.5 10.3 9.2 8.3
X2 276,362 24.8 23.9 20.0 21.6 20.5 18.1
X3 73,324 10.6 12.1 10.8 13.3 15.1 13.0
X4 239,775 9.4 8.1 6.5 14.3 13.7 10.7
X5 13,537 8.5 4.7 4.6 15.5 10.2 9.7
Average (Peer) 129,213 11.8 10.7 9.3 15.0 13.8 11.9
Name P/B ROE
Year 1FY 2FY 3FY 1FY 2FY 3FY
X1 1.1 1.0 0.8 11.5 11.2 11.1
X2 2.0 1.8 1.4 9.2 8.8 7.9
X3 1.7 2.1 1.8 12.0 15.0 15.0
X4 2.3 2.0 1.7 14.6 14.5 17.8
X5 1.1 1.0 1.0 7.2 9.1 10.3
Average (Peer) 1.6 1.6 1.3 10.9 11.7 12.4

10. Valuation: Relative
2) Based on Forecasted Fundamentals…
An approach of relating a price multiple to fundamentals through a DCF model.
P/E P/B P/S
P0 D1 / E1 1 − b P0 ROE − g P0 ( E0 / S0 )(1 − b)(1 + g )
= = = =
E1 r−g r−g B0 r−g S0 r−g
P0 D0 (1 + g ) / E0 (1 − b)(1 + g )
= =
E0 r−g r−g
Assuming stable growth, g…

11. Residual Income…
Residual income = Net income – Equity charge
RI = NI − r × BVBeginning
∞
( ROEt − r ) × Bt −1
V0 = B0 + ∑
t =1 (1 + r )t
Similar to EVA concept
Current book value forms major part of the intrinsic value

12. Appropriateness of model
• DDM models are suitable for dividend paying stocks, where company has a
discernible dividend policy that has understandable relationship to its
profitability and investor has a minority ownership perspective.
• FCF approaches might be appropriate when company does not pay
dividends or dividends differ substantially from cash flows, FCF align with
profitability or investors take a majority control perspective.
• The residual income approach can be useful when the company does not
pay dividends or free cash flow is negative.
• The key idea behind the use of P/Es is that earning power is a chief driver
of investment value.
• EV/EBITDA maybe more appropriate than P/E for comparing companies
with different amounts of financial leverage (debt). Frequently used for
capital intensive business.
• Book value is viewed as appropriate for valuing companies having mainly
liquid assets such as those in BFSI segment. Also useful when companies
are not expected to continue as a going concern.

13. Thank you