Designed for understanding of equity valuations for tech guys in various start-ups, this is a quick and simple re-cap on equity valuations. A small handbook for everybody's use in simple, lucid and day-to-day language.

1. Equity Valuation
CA Vatsal Shah

2. Valuation
• Valuation is the process of determining worth of an asset/liability.
• Valuation is not an exact science and value of an asset may differ from person to person based on
perception and utility of the asset.
• Valuation helps determine underlying value of the asset, while price is what the asset is
transacted at.
• Valuation aides a negotiator to benchmark the price of the asset. It acts as an indicative value.

3. Equity / Business Valuation
Introduction and Need
• Equity or business valuation helps in determining the value of the shareholders’ or owner’s
economic interest in the underlying business.
• Inclusive list of the purposes for which business valuation would be required are –
1. Mergers & Acquisitions
2. Business Restructuring
3. Regulatory and Financial Reporting
4. Fund Raising
5. Active and Passive Investing
6. Arbitration

4. Equity / Business Valuation
Valuation Approaches - Introduction
Primarily, there are 3 approaches to Business Valuations -
1. Income Approach
2. Market Approach
3. Asset Approach

5. 1. Income Approach (or the Discounted Cash Flows Approach)
 Based on earnings and cash flows generating abilities of the underlying company.
 Applies to companies whose past operations would not be indicative of the future.
 Also applicable to businesses having finite life.
Eg – early stage / startup / growth stage companies, companies with paradigm change in
strategies, projects of fixed tenure, mines, companies involving a marked shift in capital
structure
Equity / Business Valuation
Valuation Approaches - Introduction

6. 2. Market Approach
 Based on market determined prices of the same or similar assets.
 Applies to companies who have stable operations and have a long term maintainable set of
revenues and profitability indicators.
 Generally not applicable for companies with novel business ideas.
Eg – mature stage companies, companies envisaging similar long term stable capital structure.
Equity / Business Valuation
Valuation Approaches - Introduction

7. 3. Asset Approach
 Based on fair values of the underlying assets the business holds.
 Values the companies basis current financials and does not factor future potential of
business.
 Generally applies to companies which do not fall within “going concern” category.
Eg – companies under liquidation, asset intensive companies, loss making companies, investment
or holding companies.
Equity / Business Valuation
Valuation Approaches - Introduction

8. Equity / Business Valuation
Valuation Approaches
• Income Approach

9. Equity / Business Valuation
Income Approach
• Generally, Income Approach involves valuing a company using the following –
1. Free Cash Flows to the Firm (FCFF) –
Wherein cash flows (explicit period and terminal value) at the ENTERPRISE LEVEL are
discounted with the company’s Weighted Average Cost of Capital to arrive at Enterprise
value (EV). Thereafter,
EQUITY / BUSINESS VALUE = FCFF or Enterprise Level Cash Flows – Net Debt
2. Free Cash Flows to Equity (FCFE) –
Wherein cash flows (explicit period and terminal value) attributable to the equity owners
are discounted using company’s cost of equity to arrive at the Equity Value of the
company

10. Equity / Business Valuation
Income Approach
• Key Inputs –
i. Projected Revenues and Costs
ii. Projected Capital Expenditures
iii. Projected Working Capital Investments
iv. Horizon or Explicit Period
v. Discount Rate as calculated using CAPM
vi. Terminal Value

11. • Determination of Cost of Equity –
Under normal course of valuations, discount rates are determined using the Capital Asset Pricing
Method which estimates the return which a rational investor would expect from his/her
investment in equity shares of a company. Thus,
Ke = Rf + (Market Returns – Rf) * Beta + Alpha where –
Ke is the cost of equity for the company or the return on equity for the investor and Rf is the Risk
Free returns in the economy.
Market returns represent the returns on equity which the investor would earn by investing in
general equity market in the economy. For India it would imply returns on Nifty or Sensex.
Equity / Business Valuation
Income Approach
Risk Free
Returns from General Equity Investing
Returns from Investing in Equities of Specific Sector

12. Equity / Business Valuation
Income Approach
• Determination of Cost of Equity –
Ke = Rf + (Market Returns – Rf) * Beta + Alpha
Beta, calculated using betas of comparable companies in the industry, aides in calculating the
returns expected from investments in equities for the specific industry (considering additional
risks of investments in that industry vis-à-vis broad equity markets) in which the company
operates.
Alpha or Risk Premium or Company Specific Risk represents the additional return an investor
would expect for undertaking the risk of investing in a specific company.
Risk Free
Returns from General Equity Investing
Returns from Investing in Equities of Specific Sector

13. • Determination of WACC –
WACC is determined as an extension to cost of equity.
Weighted Average Cost of Capital (WACC) = We * Ke + Wd * Kd
Kd is the cost of debt,
Ke is the cost of equity,
We is the weight of equity in the capital structure of the company
Wd is the weight of debt in the capital structure of the company
The Debt to Equity ratio, which determines the weights, would be determined basis the
availability of debt available to the company and the company’s long term Target Debt to Equity
structure which the company envisages to maintain.
Equity / Business Valuation
Income Approach

14. Equity / Business Valuation
Income Approach
• Determination of FCFF –
Earnings Before Interest and Taxes
Less: Taxes
Earnings after Taxes
Add: Depreciation
Less: Further Capital Expenditure
Less: Incremental Working Capital Expenditure
Less: Incremental Long Term Investments
Free Cash Flows to the Firm or Enterprise Level Cash Flows

15. Equity / Business Valuation
Income Approach
• Determination of FCFE –
Earnings Before Interest and Taxes
Less: Interest
Earnings before Taxes
Less: Taxes
Earnings after Taxes
Add: Depreciation
Less: Further Capital Expenditure
Less: Incremental Working Capital
Less: Incremental Long Term Investments
Less: Net Repayment of Debt
Free Cash Flows to Equity

16. Equity / Business Valuation
Income Approach
• Determination of Terminal Value –
Post determination of cash flows for the explicit or horizon period, a terminal value has to determined
to account for value created by cashflows until eternity. Two widely used methods are as follows -
Some of the methods are –
1. Expected Target Multiple – EV/FCFF or Equity Value/FCFE or other market multiples.
2. Gordon Growth Model -
Normal Growth Model –
(FCFF or FCFE of last explicit period)*(1+g)/(Ke-g)
Where,
Ke is the cost of equity,
g is normalized rate of growth in business
operations expected post explicit period
H - Model –
{(FCFF or FCFE of last explicit
period)*[(1+g)+(short term growth rate –
normalised growth rate)*(period to normalized
growth rate)/2]} /(Ke-g)
Where,
Ke is the cost of equity,
g is normalized rate of growth in business
operations

17. Equity / Business Valuation
Valuation Approaches
• Market Approach

18. Equity / Business Valuation
Market Approach
Market Approach derives value of equity using value of the same or similar asset determined in an
active market with varied market participants. Generally, it comprises of 3 techniques –
1. Market Price Method
2. Comparable Companies Multiples Method
3. Comparable Transactions Multiples Method
• Market Price Method
This method is considered when the underlying equity being valued is actively traded on stock
exchanges and the price at which it is traded is considered to be the fair value of the company.

19. Equity / Business Valuation
Market Approach
• Comparable Companies Multiples Method (CCM) & Comparable Transactions Multiples (CTM)
Method
These methods are used when the underlying equity being valued is not actively traded on the
stock exchanges.
Under the CCM Method, market price multiples of comparable companies are used to value the
underlying equity,
In CTM method, valuation multiples of recent transactions (preferable dating back to a maximum
of 2 years) involving companies in similar businesses are considered for evaluation of underlying
equity.
Specific adjustments to CCM and CTM maybe required for adjustments pertaining to size,
illiquidity, marketability and operational stage

20. Equity / Business Valuation
Market Approach
• Comparable Companies Multiples Method (CCM) & Comparable Transactions Multiples (CTM)
Method
Profitability based –
• EV/EBITDA
• EV/(EBITDA-Capex)
• EV/EBIT
• P/E
Revenue based –
• EV/Revenue
• Market Cap/Revenue
Asset or Equity based –
• Price/Book Value
• Price/Adjusted Book Value
• EV/Assets
• Market Cap/Assets
Operating Matrix based
(inclusive list) –
• EV/Tonne
• EV/Barrel
• EV/GMV
• EV/Subscriber
• EV/Tower
Applicability / consideration of the multiples would depend on the type
of the company and the respective circumstances

21. Equity / Business Valuation
Market Approach
• Comparable Companies Multiples Method (CCM) & Comparable Transactions Multiples (CTM)
Method
Profitability Multiples –
• Used for companies having decent profitability
• EV multiples generally used when companies have debt
in their capital structure
• Also, EV multiples are generally preferred when non the
company has significant non operating, other income
Revenue Multiples –
• Applicable when the underlying company is loss making
• Not preferable for companies having different cost
structures
• One of the methods used for valuing startups, though
mostly they are target/exit multiple based and not
depended on market inputs
Asset or Equity Based Multiples –
• Considered for companies whose assets would be
money-like in nature and would show/represent their
fair value. Eg – Banking and NBFC sectors
• Would be used as a corroborative method of valuation
for asset intensive companies
Operating Matrix based Multiples –
• Can be considered only when the operating matrices are
available
• One of the methods to value companies with lower or
negative profitability, lower revenues like startups
• For startups, these could be target/exit multiple based
and not depended on market inputs

22. Equity / Business Valuation
Valuation Approaches
• Asset Approach

23. Equity / Business Valuation
Asset Approach
Asset Approach involves computation of Adjusted Net Worth of the company -
Book Value of Assets
Less: Book Value of Liabilities
Net Worth or Shareholder’s Funds
Adjustments -
Less: Incremental Fair Value of Liabilities
Add: Incremental Fair Value of Assets
Less: Contingent Liabilities
Adjusted Net Worth

24. Equity / Business Valuation
Key Points for Valuation of Start-Ups
• Assumptions underlying financial projections should be realistic in nature. They should be
adequately substantiated with in-depth market study.
• Some of the key assumptions would be –
i. Growth in revenues and underlying revenue drivers, market study,
ii. Cost assumptions, especially costs required for commensurate increase in scale of business
operations
iii.Tax Computations
iv. Assumptions regarding availability and usage of debt, preferred equity, etc
v. Fixed capital expenditures, capacity utilization and leverage
vi. Requirement of Working Capital
vii.Viability of the company under different scenarios

25. Equity / Business Valuation
Key Points for Valuation of Start-Ups
• Based on the extent of risk involved in the business operations of the startup, discount rate for
would generally range from 25% to 70%. It is highly subjective in nature and depends on the
following factors (inclusive list) –
i. Experience of Management in the respective field
ii. Novelty of the business idea
iii.Stage of Operations (revenue generation, cash flows, profitability)
iv.Stage of Funding (Seed funding, Series Funding)
v. Perception of the investor
vi.Negotiating skills
• The discount rate or cost of equities could be separate for each stage of funding since initial
round funding may have a priority on cash flows over subsequent rounds.

26. Equity / Business Valuation
Key Points for Valuation of Start-Ups
• A study undertaken by professor Damordaran shows how discount rates span depending on the
stage of the start-up -
• Alternatively, companies are valued on the basis of revenue or operating matrix multiples.
However, in absence of comparable market information, it is generally depended on the target
acquisition and exit multiples which the investor is comfortable with.
• It is the responsibility of the management of the start-ups to provide financial projections for
valuations. However, managements can hire corporate finance advisors or build an internal
corporate finance team for the same.
Stage of Development Discount Rates
Start-Up 50-70%
First Stage 40-60%
Second Stage 35-50%
Bridge/IPO round 25-35%

27. Thank You