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Business Valuations

Business Valuations. Highly visible companies tend to be called as market leaders because of various competitive advantages enjoyed by them. Does that mean we should buy their equity shares? In the long run prices tend to gravitate towards the fair value of the assets.

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Business Valuations

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  1. Business Valuations Highly visible companies tend to be called as market leaders because of various competitive advantages enjoyed by them. Does that mean we should buy their equity shares? In the long run prices tend to gravitate towards the fair value of the assets. Hence Valuation( estimation of fair value) forms the basis for equity Analysis and also for business valuations for acquisitions etc.

  2. Business Valuations • Fair Value/Intrinsic Value:- ia the value at which if the investor invests he will get a return equal to his required rate of return. • Comparing the estimates value to the market price gives opinion on under-valuation( buy decision) and over-valuation( sell decision) of a share.

  3. Business Valuations • Types of Valuation Models: • DCF Models:- • Dividend Discount Model. • FCFF Discount Model. • FCFE Discount Model. _ Relative Valuation Models( Comparable Multiple):- • Price/Earnings Multiple • Price/Cash flow Multiple • Price/Book Value multiple • Price/Sales Multiple • EV / EBITDA multiple.

  4. Business Valuations • DCF Model: Dividend Discount Model • Assumes that dividend is the only source of income for an equity investor. • Discount rate applied will therefore be the Cost of Equity. • Discounted value of dividends directly give the value of the equity. • Value of the equity divided by the no. of equity shares outstanding give the fair value per share

  5. Business Valuations • DCF Model-FCFF Discount Model • Cash flow available after all direct costs and investments but before any payments to the capital suppliers( both debt and equity) is referred as Free Cash Flow to Firm ( FCFF) - Hence suitable discount rate is the WACC of the firm. _ Value obtained after discounting these cash flows is the total value of the firm. - To get the value of equity, deduct the value of debt obligations from the total. - Value of equity is divided by the no. of equity shares outstanding to get the fair value per share.

  6. Business Valuations • DCF Model:- FCFE Discount Model • Free Cash Flow to Equity (FCFE) is the cash available after all costs, investments and payments to debt providers. • Appropriate discount rate for this would be the Cost of Equity to the firm. • The discounted value will directly give the Value of Equity which is further divided by no. of equity shares outstanding to get the fair value per share.

  7. Business Valuations • RELATIVE VALUATION MODELS • DETERMINES AN ASSET’S VALUE RELATIVE TO THAT OF A SIMILAR ASSET. • BASIS IS THAT SIMILAR ASSETS SHOULD SELL AT SIMILAR PRICES. • VALUE ESTIMATED AS MULTIPLE OF CERTAIN KEY VARIABLES. • Limitation:- undervalued/overvalued opinion is only in relation to similar asset ( whose value may again be questionable) • Hence the model is more in the nature of a thumb rule and not deep analysis as DCF Models.

  8. Business ValuationsRelative Valuation Models • Price Earning Ratio or Multiple:- • Market price of equity shares / EPS • Calculated on the basis of the previous 4 quarter earnings-Trailing P/E • Calculated on the basis of the estimated earnings of next 4 quarters-Forward/leading P/E • Compared with the P/E of the Peer companies or Industry average P/E or historical P/E multiple. • Limitations- Sustainable EPS? /Negative Earnings ?

  9. Business ValuationsRelative Valuation Models • Enterprise Multiple:- EV /EBITDA • EV is =the sum of company’s market cap + total debts (including long and short term debts) less cash and investments. • A low ratio indicates that co. may be undervalued. • Useful for takeover decisions. • A co. with a low Enterprise multiple can be viewed as a good takeover candidate

  10. Business Valuations Relative Valuation Models • Price/Cash Flow Multiple/Ratio • Market Price of share/ EBITDA or free cash flow • More reliable denominator. • No danger of negative cash flow-hence even companies with negative EPS can be valued.

  11. Business Valuations Relative Valuation Models • Price to Book Value Ratio • Empirically strong relationship of this ratio with stock returns. • Co. with low P/BV are expected to generate higher returns. • Benchmark value is peer group or Industry average. • Valuation of Finance Companies and Banks • Valuation of companies with negative or negligible earnings.

  12. Business Valuations Relative Valuation Models • Price/ Sales Ratio • Basis that sales are least susceptible to manipulation. • Growth in sales indicate ability of the company to earn better in future even if not at present. • Companies with strong brands-FMCG companies /Pharma companies are valued on this model.

  13. Business ValuationsDividend Discount Model • Cost of Equity:- • CAPM Model:- Re = Rf + b * (Rm-Rf) • Rf=Risk free rate-6% • Beta 1.2 • Rm=12%(expected return) • Re = 0.06 + 1.2( 0.12-0.06) = 0.132=13.2%

  14. Business ValuationsDividend Discount Model • Estimating the Dividends:- • Higher the payout lower the money available for reinvestment and hence lower the Growth. • Growth in Earnings= Reinvestment rate *ROE • Reinvestment Rate=Growth in earnings/ROE • Growth in earnings expected-10% and ROE is 25%. • Then Reinvestment Rate=10/25*100=40% • Therefore Dividend payout is not likely to be more than 60%

  15. Business Valuations Dividend Discount Model • Po=current estimated value of the share. • D1, D2, Dn= dividends per share in future period. • Re= cost of equity • Po = D1 / (1+Re)^1 + D2 / (1+Re)^2….. • Gordon’s Growth Model:- • Po = Do (1 + G) /(Re –G) • Fair Value of share= 5 (1+0.10) /(0.132-0.10)= Rs. 171.80

  16. Business ValuationsFCFF and FCFE • FCFF = PBIT + DEP- Cash Tax- Tax advantage on Interest- W/Capital – Capex • FCFE = NP + DEP – W/Capital –Capex + Net Borrowings.

  17. Business ValuationsFCFF and FCFE • Terminal Value calculation:- • FCFFt ( 1 + G) WACC – G OR • FCFEt ( 1 + G) Re - G The terminal values together with other period free cash flows are converted to present value to find the value of the firm or equity i.e using FCFF or FCFE respectively.)

  18. Business Valuations-a summary Various valuation approaches are followed:- • Adjusted Book value approach( minimum pricing) • Stock & Debt approach.( actively traded) • Direct Comparison approach (comparative multiples) • Discounted Cash Flow approach • Dividend Discount approach • Sum of parts valuation

  19. Business Valuations • Selection of suitable Valuation Models:- • An IT( technology) stock- ?? • A Bank equity - ?? • For a minority shareholder - ?? • Long-term business valuation - ?? • Valuation of an unlisted company -?? • FMCG and Pharma Companies ?? • Companies with high dividend payout ratio and stable dividend policy ??

  20. Business Valuations-a summary • Test at least through 2 approaches for valuation. • Theory Vs. Judgment. • Fix value range before negotiation. • Adopt flexibility in Discount factor. • Avoid reverse engineering. • Avoid pitfalls.

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