K J SOMAIYA INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

A Discussion on the Various Approaches to Valuation

A Seminar Paper
Pulkit Dev Lambah, PGDM Finance, Roll No 007 15/12/2010

Under The Guidance of Prof. Jayendran SIMSR

The objective of this research is to provide an overview about the different approaches used for valuing a firm and discussing the various methods within these approaches. 1

CONTENTS
A Discussion on the Different Approaches to Valuation..................................................................................... 3 Discounted Cash Flow Approaches ............................................................................................................... 3 Dividend Discount Model .......................................................................................................................... 3 Free Cash Flow to Equity ........................................................................................................................... 4 Free Cash Flow To Firm ............................................................................................................................. 5 Relative Valuation Techniques ...................................................................................................................... 6 Price to Earnings ratio............................................................................................................................... 6 Price to Book Value ratio .......................................................................................................................... 7 Price to Sales ratio .................................................................................................................................... 7 Price to Cash Flow ratio ............................................................................................................................ 8 Discounted Cash Flow V/S relative valuation Methods .................................................................................. 9 Applicability of methods with respect to Scenario ..................................................................................... 9 Applicability Of Methods With Respect To Sector .................................................................................... 10 Conclusions ................................................................................................................................................ 10 References ..................................................................................................................................................... 11

A DISCUSSION ON THE DIFFERENT APPROACHES TO VALUATION

Valuation can be considered the backbone of finance. It is widely used across all branches of finance, be it corporate finance, portfolio management, equity analysis and many other fields. In corporate finance the objective is to maximize firm value by altering financing, investment and dividend decisions. In portfolio management, resources are spent to find undervalued firms and then a profit is sought to be made as prices converge to market value. In studying efficient markets also, valuation is used to find out whether prices divert from their true value, and if they divert, how soon do they revert. Hence, Understanding what determines the value of a firm and how to estimate that value seems to be a prerequisite for making sensible decisions. There are two broad approaches to valuation: - the relative valuation methods and the discounted cash flow techniques. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable such as earnings, cash flows, book value or sales. Discounted cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. This discussion will focus on these two broad approaches and the techniques used within these approaches for valuation of a company. This discussion will use Reliance Industries Limited as an example to elaborate each of the valuation methods explained in the following sections.

DISCOUNTED CASH FLOW APPROACHES

In the discounted cash flow approaches, the value of the stock is estimated based upon the present value of some measure of cash flow, including dividends, operating cash flows and free cash flows. A potential drawback to these cash flow techniques is that they are very dependent on the two significant inputs a) the growth rates of cash flows (both the rate of growth and duration of growth) and b) the estimate of discount rates. A small change in either of these values can have a significant impact on the estimated value.

DIVIDEND DISCOUNT MODEL

When investors buy stock in publicly traded companies, they generally expect to get two types of cash flows dividends during the holding period and an expected price at the end of the holding period. Since this expected price is itself determined by future dividends, the value of a stock is the present value of dividends through infinity. The most straightforward measure of cash flows is dividends because these are cash flows that go directly to the investor, which implies that we can use the cost of equity as the discount rate. The dividend discount model (DDM) is relevant while valuing a firm that is stable, mature and has a relatively constant growth for the long term. However, this dividend technique is difficult to apply to firms that do not pay dividends during periods of high growth or that currently pay very limited dividends because they have high rate of return investment alternatives available. The DDM s main attraction to investors is its inherent simplicity and the fact that sometimes, dividends represent the only cash flows from the firm that is tangible to investors. In addition, we need fewer assumptions to get forecasted dividends than to forecast free cash flows. Another solid argument can be that management sets the dividends at such a level that can be sustained even in the face of volatile earnings. The DDM has its drawbacks that include firms either paying too much or too less in dividends than what they have available in cash flows. If the dividends are too less than the cash flows of the firm, the FCFE increases the dividends , cash balances are build up. The DDM undervalues the claim of equity shareholders on these cash

balances. On the other hand, if firms pay much more dividends than what they have in cash reserves, funding the gap with new debt or equity issues, the DDM generates an overly optimistic value estimate. Firms in mature businesses with stable earnings try to calibrate their dividends with their cash flows. The DDM can be useful in valuing such firms. Examples of such firms include utility companies such as phone and power companies. In addition, in sectors where cash flow estimation is difficult, dividends are the only cash flows that can be determined with a degree of precision. The DDM is apt for valuing financial services firms for two reasons. First, calculating free cash flows for a bank, insurance or financial services firm is very tough as it is really hard to estimate working capital and capital expenditures for these firms. The second reason is that retained earnings and book equity have real consequences for financial services companies since their regulatory capital ratios are computed based on book value of equity. There are many variations to the DDM developed over time. The simplest extension of infinite DDM is a twostage growth model where there is an initial phase with a growth rate that is not stable, followed by a subsequent steady state where growth is stable and expected to remain so for the long term. Based on Infinite growth Dividend Discount Model, Value of stock = Expected dividends next period / (Cost of equity Expected growth rate in perpetuity). Using the above method to value RIL, assuming a stable growth rate of 10% (which is the growth rate for the past 2 years, i.e. 2009 and 2010), we getDividend Discount Model Value as on 31 Mar 2010 Assuming stable growth = 10% Price of Stock (Present Value) No of Shares Outstanding(in Cr) Market Value of Equity (in Cr) Market Value of Debt (in Cr) Value of Firm (in Cr) 2010-11 (E)

Rs. 1,010.52 327.03 Rs. 3,30,470.82 Rs. 62,494.69 Rs. 3,92,965.51

FREE CASH FLOW TO EQUITY

Another measure is free cash flow to equity which is a measure of cash flows similar to the operating free cash flow, but after payments to debt holders, which means that these are cash flows available to equity holders, therefore the appropriate discount rate is the firms cost of equity. When we use the FCFE model to value a firm, we are implicitly assuming that the FCFE will be paid out to stockholders. Hence, we assume that there will be no cash build up in the firm, since cash available after debt payments and reinvestment needs is paid out to stockholders. In addition, the expected growth in FCFE is due to growth in income from operating assets and not growth in income from increases in marketable securities. The FCFE model is apt for valuing firms whose dividends are significantly higher or lower than the FCFE. It gives a realistic value of high-growth firms that might be expected to have negative FCFE s in the near future.The discounted value of these negative cash flows captures the effect of the new shares that will be issued to fund the growth during the period, and thus captures the dilution effect of value of equity per share today.

The FCFE model is quite similar to the DDM model, and often gives a higher value of the firm than that calculated under the DDM model. The question as to which model s value is more appropriate is answered by the openness of the market for corporate control. If there is a high probability that the firm can be taken over and its management changed, the market price will reflect that likelihood and the value from FCFE model is more appropriate. As changes in corporate control become more difficult, either due to the firm s size, or legal/takeover restrictions, the value from DDM is more appropriate. The assumptions and inputs required both for FCFE and FCFF method valuation of RIL are as follows: Beta Risk Free Rate Sensex Return Cost of Debt 1 - Tax Rate After Tax Cost of Debt Cost of Equity (CAPM) Stable Growth Rate (after Supernormal Growth) 1.13 7.27% 10.30% 3.40% 82.96% 2.82% 10.69% 6.50% (based on 3 Year QoQ returns) (1 yr T-Bill Yield) (1 yr Monthly HPY) (Average Yearly Effective Interest Rate) (Average Yearly Effective Tax Burden)

The value of RIL using the FCFE method and multistage growth assumption is calculated as follows. Here FCFE is calculated as FCFE = Net income + Depreciation issued Debt repayments) Capital expenditures Change in non-cash working capital (New debt

2009-2010 Free Cash Flow to Equity Terminal Value of Equity at 2013 Present Value Factor Present Value Market Value of Equity (in Cr) Market Value of Debt (in Cr) Value of Firm

2010-11 (E) 1496.52 0.90 1351.94

2011-12 (E) 6968.44 0.82 5687.06

2012-13 (E) 16866.54 428309.4223 0.74 328216.68

Rs. 4,53,640.92 Rs. 62,494.69 Rs. 5,16,135.61

FREE CASH FLOW TO FIRM

The third type of cash flow is the operating free cash flow, which is described as cash flows after direct costs and after allowing for cash flows to support working capital expenditure and capital expenditures required for future. The discount rate used in this case is the weighted average cost of capital because it deals with cash flows for all capital suppliers to the firm. It is useful to value firms with diverse capital structures because the value of the total firm is determined and then the firm s debt is subtracted to get the value of the firm s equity. It is the cash flow after taxes and reinvestment needs, but before any debt payments. The primary difference between equity and debt holders in these firm valuation models lies in the nature of their cash flow claims lenders get prior claims to fixed cash flows and equity investors get residual claims to remaining cash flows. The Valuation of RIL using the FCFF method is done as follows, where FCFF is calculated as

Free cash flow to firm = After-tax operating income cash working capital

(Capital expenditures

Depreciation)

Change in non-

2009-2010 Free Cash Flow to Firm Debt to Equity Ratio Weight of Debt Weight of Equity WACC Present Value Factor Terminal Value of Firm at 2013 Present Value Value of Firm

2010-11 (E) 8101.03 0.45 31.16% 68.84% 8.24% 0.92 7484.30

2011-12 (E) 12961.82 0.43 30.31% 69.69% 8.31% 0.85 11049.65

2012-13 (E) 19539.24 0.39 28.23% 71.77% 8.47% 0.78 1055484.32 842307.31

Rs. 8,60,841.26

RELATIVE VALUATION TECHNIQUES

The relative valuation techniques provide information about how the market is currently valuing stock at several levels, that is, the aggregate market, alternative industries and individual stocks within the industries. One disadvantage of relative valuation is that it does not to provide guidance on whether these current valuations are appropriate, that is, valuations at a point in time could be too low or too high. The relative valuation techniques are appropriate to consider under two conditions: 1. There is a good set of comparable entities i.e., comparable companies that are similar in term of industry, size and risk. 2. The aggregate market and the company s industry are not at a valuation extreme, that is, they are not seriously undervalued or overvalued. In this discussion the following relative valuation ratios will be covered: - a) price/earnings (P/E), b) price/cash flow (P/CF), c) price/book value (P/BV) and d)price/sales (P/S)

PRICE TO EARNINGS RATIO

Earning power is the chief driver of investment value, and EPS is perhaps the chief focus of any security analyst s attention. P/E is widely recognized and used by investors. Both Financial analysts as well as professional investors rank the simple P/E ratio method as the most important valuation model. However, in some cases, the EPS might be negative and P/E may not make economic sense. Also, earnings often have volatile components, making the analyst s task difficult. They also vary with accounting practices. The two chief definitions of P/E are trailing P/E and leading P/E. a stock s trailing P/E is its current market price divided by its most recent 4-quarter s EPS. In such calculations, EPS is referred to as trailing 12 months EPS. The leading P/E is defined as the stock s current market price divided by the next years expected earnings. Different industries and sectors may have different ranges of P/E ratios that are considered to be normal for that particular industry. One way to find out if a particular sector is over(under)priced is when the average P/E ratio of all the companies in the industry is far above(below) the historical average. The P/E ratios of some

types of companies (e.g. software manufacturers) are all generally higher than P/E ratios for companies in other industries (e.g. auto manufacturers) The P/E for a stock is a function of both the level and quality of its growth and risk.

PRICE TO BOOK VALUE RATIO

Book value per share (BVPS) attempts to represent the investment the company s shareholders have made in the company on a per-share basis. As a measure of net asset value per share, BVPS has been viewed as appropriate for valuing companies composed chiefly of liquid assets such as finance, investment, insurance and banking institutions. For such companies, book value of assets may approximate market values. Book value has also been used for valuation of companies that are not expected to continue as a going concern. Because BVPS is more stable than EPS, P/BV may be more meaningful than P/E when EPS is abnormally high or low, or is highly variable. Book value is also generally positive. Some drawbacks of P/BV are it does not recognize intangible assets and human capital, difference of average age of assets among companies being compared and inflation effects. It is calculated as Shareholder s equity minus total value of equity claims that are senior to common stock on a per-share basis. A P/BV ratio of greater than one indicates that the stocks are priced at greater than their historical book values in the market. In times when the economy is in a boom phase, historically, companies have traded above the P/BV ratio of two indicating the upside/potential that stocks below their current book value would carry. However, P/BV varies quite a bit with respect to the industry. Companies that require more infrastructure and physical capital usually trade at much lower P/BV s than companies which say, require more human capital, say consulting firms. A higher P/BV usually indicates that the investors expect the management to generate more value from a given set of assets. It also gives some idea of whether an investor is paying too much for what he would get in case the company went bankrupt.

PRICE TO SALES RATIO

Certain types of privately held companies, including investment management companies and companies in partnership form have long been valued as a multiple of annual revenues, thus the ratio of price to sales has become well known as a valuation multiple for public traded companies. Sales are generally less subject to distortions and manipulations as compared to other fundamentals such as EPS or book value. Sales are positive even when EPS is negative. Also, because sales are generally more stable than EPS, which reflects operating and financial leverage, P/S is generally more stable than P/E. Some drawbacks of P/S are it does not always reflect profitability, cost structure and might be subject to manipulation via revenue recognition practices. It is calculated as Price per Share divided by annual net sales per share. The P/S ratio is appropriate for valuing companies or industries which are cyclical in nature and are vulnerable to the business cycle such as the construction and automotive industries. Based on the economic conditions, 7

these firms will have large shift in their earnings power, making their earnings figures less reliable. During these periods, the stocks may become depressed in value and the price to sales ratio can help investors find bargains within the sector. Some analysts claim that it is best suited for large cap companies as they can keep up the large sales they generate. It also is difficult to use it for the services companies, because they don t make any sales, just provide different types of services.

PRICE TO CASH FLOW RATIO

Price to cash flow is a widely used valuation indicator. Cash flows are usually less subject to manipulation than earnings. They are generally more stable than earnings. Using P/CF rather than P/E addresses the issues of accounting conservatism between companies. When the EPS plus noncash charges approximation to cash flow from operations is used, items affecting actual CFO such as non cash revenues and net changes in working capital are ignored. Free cash flow rather than cash flow is viewed as the appropriate variable for valuation. We can use the price to free cash flow to equity, but it has a possible drawback of being more volatile compared to Cash flow , for many businesses. FCFE is also more frequently negative than cash flows. Price-to-cash-flow ratios vary widely from industry to industry, with capital-intensive industries such as auto manufacturing or cable TV tending to have very low multiples, and less infrastructure-heavy industries, like software, having higher P/CF ratios. The P/CF ratio is generally used to value companies in the hard asset business such as gold, oil and real estate companies. In the following tables the valuation of RIL is done using the various multiples. The multiples are assumed to remain constant in the forecasted years, and the expected stock price in the forecasted years is calculated by taking a geometric mean of the stock price forecasted by each of the relative valuation methods. 2009-10 1010.40 49.65 419.44 608.11 24.63 2010-11 (E) 1551.5997 82.99 479.68 754.26 57.75 2011-12 (E) 1981.1232 107.97 558.49 935.53 81.70 2012-13 (E) 2527.8951 140.08 661.45 1160.37 113.64

Market Price as on 31-03 EPS BVPS Sales Per Share Cash Flow Per Share (EBITDA per Share)

Relative Valuation Ratios as on 31-32010 P/E P/BV P/S P/CF

20.35 2.41 1.66 41.03

Market Price Assuming constant valuation ratios 1689.1091 2197.5188 2850.8904 1155.5125 1345.3387 1593.3803 1253.2353 1554.4326 1928.0184 2369.4841 3352.0447 4662.5666

DISCOUNTED CASH FLOW V/S RELATIVE VALUATION METHODS

The two approaches to valuation will almost always yield different values for the same asset/firm at the same point in time. It might be possible that one approach states that the stock is undervalued whereas the other says its overvalued. Even using different methods within these approaches, we can arrive at different values for the same firm. The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency. In discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average. No one method is correct or superior to the other. It is the accuracy and consistency of the estimates of the inputs required for these methods that will give a more accurate or superior value.

APPLICABILITY OF METHODS WITH RESPECT TO SCENARIO

y Start-ups- Startups are driven by far too many factors to be captured by simplistic valuation models. Their sensitivity to Economic, Sector Specific and Company specific factors must be captured as far as possible to reasonably value them. These factors can only be captured with the DCF method. Matured Companies, have fairly predictable financials and hence DCF will result in a fairly reliable valuation. However, the Dividend Discount Model will also work reliably, as matured companies have nominal expansion needs and hence a high dividend payout ratio along with predictability of growth rates. E.g. Large FMCG companies IPOs - Although, for such situations it is best to use DCF as it determines the intrinsic value, not many will want to use it as it is likely to understate value as against Comparable valuation. Simply because, the idea behind an IPO is to raise maximum possible capital for a minimum dilution in equity. Hence most IPOs come out in bull markets where valuations are already high and Comparable Valuation will result in higher values as compared to DCF, as a result of circularity involved in such the approach. Consequently, IPOs are demand driven rather than intrinsic value led, as a result many average companies get extraordinary valuations. High growth companies have drastically changing market shares and hence it is very difficult to compare them with a benchmark, making comparable valuation difficult and leaving one to go with the DCF approach. E.g. Telecom companies Cyclical Companies, by virtue, have a very high degree of uncertainty. Secondly, such companies are always on the radar for news & management comment both of which are immediately reflected in Comparables. On the other hand, DCF may have to wait for a quarter or more to reflect a change. E.g. Sugar Companies Distressed company valuation, is particularly tricky as the challenge lies in finding fair value and not the lowest value. By distressed, it means loss making companies or those that are restructuring their businesses by selling off toxic assets and toning down capital structure. Traditional valuation approaches fail miserably as a result of the uncertainty involved and this is where Liquidation Value & Replacement cost method come in to play. Liquidation Value measures return from selling off or liquidating the assets while Replacement Cost measures the opportunity cost of setting up a business. E.g. Many Textile Companies

APPLICABILITY OF METHODS WITH RESPECT TO SECTOR

y Steel & Cement represent basic/building materials. The sectors are cyclical (driven by expansion cycles). Being cyclical, in normal/bullish scenarios Comparables approach is best suited. However, in downturns it is better to shift to Asset based approaches to reflect maximum downside potential. IT & ITes companies have very complicated business models where revenues are scattered & unpredictable, face constant threat of protectionism and so one simply cannot have a reliable long term forecast. Hence Comparables is chosen over DCF by most. However, we suggest the use of DCF in very bullish/bearish markets. The Telecom sector, has rich & abundant data availability to generate very reliable numbers over a 35 year horizon and the business model can be very easily broken down into a flow of numbers. For this reason it is recommended to use the DCF approach. However, many analysts use Comparables to provide short-term targets. Healthcare / Hospitality: - these sectors too can be very easily broken down into a logical flow of numbers resulting in a reliable medium-long term forecast. Hence, DCF is a rational choice. However, asset based approaches are a must in bearish markets to determine worst case scenario valuation Infrastructure, Power and Oil & Gas together forms the Core Sector. These sectors are primarily driven by government policy and funding, the details of which are clearly made available. Having distinct drivers along with rich data, availability make it a perfect DCF candidate. Asset valuation should be used as a support. Retail- Although appearing to be simple, this is one of the most complicated sectors to value. The complexity is a result of distant breakevens, multiple formats, complex funding provisions (debt/lease/cash) and not-so-easily-quantifiable demand. This leads to a hybrid valuation approach often called SOTP Valuation

CONCLUSIONS
In this paper, we examined two different approaches to valuation, with numerous sub-approaches within each. The first is discounted cash flow valuation, where the value of a business or asset is determined by its cash flows and can be estimated by using any one of the following cash flows a)Dividends, b)Free Cash Flow to Equity and c)Free Cash Flow to the Firm. The difference in asset values arrived at using these approaches usually arises due to either inconsistent assumptions or inapplicability of the method for that particular sector or firm. The second approach to valuation is relative valuation, where we value an asset based upon how similar assets are priced. It is built on the assumption that the market, while it may be wrong in how it prices individual assets, gets it right on average and is clearly the dominant valuation approach in practice. Relative valuation is built on standardized prices, where we scale the market value to some common measure such as earnings, book value or revenues or cash flows but the determinants of these multiples are the same ones that underlie discounted cash flow valuation.

10

REFERENCES
1. L. Corteau et al.(2006), Relative accuracy and predictive ability of direct valuation methods, price to aggregate earnings method and a hybrid approach, Accounting and Finance 46 (2006), pp 553- 575. Bertoncel (2006), Acquisition valuation: how to value a going concern?, NG, T. (2006) Razprave/Discussions. Chandra and Ro (2008), The Role of Revenue in Firm Valuation, Accounting Horizons, American Accounting Association, Vol. 22, No. 2, pp 199 222. Relative Company-Valuation Methods And Lessons Of The Global Financial Crisis, Dimiter N. Nenkov (2010) India-Infoline (2010), Sector Preview, Oil and Gas Q4 FY10, April 8. JPMorgan (2010), Equity Research Report, Reliance Industries Limited , July 28.

2.

3.

4.

5. 6.

./

Accounting an d F nce 46 (2 006 ) xxxxxx ina

11