Valuation Fundamentals Finatics

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					Valuation Fundamentals
Table of Contents                                                      

                                  Table of Contents

       >   Introduction                           >   Which method is best suited ?
           – Concept of Fair Value                    – Public vs Private Company
           – Who uses Valuation?                      – By Scenario
       >   Valuation & Wealth Maximization            – By Sector
       >   Valuation Approaches                   >   Valuation FAQs
       >   Valuation Methods                          – General
       >   Is there a ‘Best’ method?                  – DCF
                                                      – Comparables

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    Equity Valuation Fundamentals
    Introduction – Concept of Fair Value                                                    

At Finatics, we define Equity Valuation as
“A process that involves determining „Fair Value‟ of a company‟s equity in order to assist buy/sell decisions for the
purpose of Financial or Strategic Investment”

So what is Fair Value of an               How should the worth of an               …(Contd)
investment?                               Investment be determined ?
Put Simply, Fair Value is the price at    As discussed, investment related         … the other way is to find out what
which, one will get the desired rate of   demand will be driven by expected        are other „similar‟ opportunities
return when the investment is sold to     return resulting from demand of          available for, and then comparing the
a willing & able buyer.                   other similar opportunities available,   extra price paid for or money saved
The worth of an investment is             potential to generate cash and           by the Asset.
determined by whether it is meant for     implied risk.                            Another approach one may use is
long term use to generate returns         When determining whether expected        determining the cost of a substitute
(i.e. Strategic Investment) or for        return can be achieved, one way is to    a.k.a. replacement cost! Valuation
resale when the „right price‟ or „fair    estimate the cash generated from         deals with understanding & applying
value‟ is achieved (Financial             the „Asset‟ against what is invested     these 3 approaches in varying
Investment). The purpose of Valuation     after considering „Time Value of         situations
is to determine a fair value range of     Money‟ (a.k.a. Net Present Value)
an investment (or capital asset) using
one or more of several available

    Equity Valuation Fundamentals
    Introduction – Who uses Valuation?                                                    

Valuation is used at two levels
– Primary, which deals with „Value Creation‟ at a Corporate Finance level
– Secondary, that deals with market intermediaries & investors

Buy Side Institutions                    Sell Side Institutions                    Corporate Finance
Buy Side refers to those institutions    Sell side are involved with               Corporate Finance refers to managing
that are engaged in buying research      recommending buy/sell decisions to        finances of a company and involves
conducted by others. They                clients. The buyers of such reports       selecting projects, creating budgets
invest/manage client‟s funds (as well    may be Retail clients, High Net-worth     & arranging funds. Their job is the
as their own) into investments in        Individuals or Institutional investors.   toughest one i.e. Creating Wealth in
primary or secondary markets.            E.g. – Brokerage Houses, Research         the secondary market through
Primary refers to direct investment in   Firms & focused KPOs                      managing expectations and delivering
companies while secondary involves       Note: Bulge bracket Investment            superior results. They use valuation
buying/selling stocks in the stock       Banks play both buy/sell side roles.      to understand gaps in expectation
market.                                                                            and performance of the firm as a
E.g. – Mutual Funds, Hedge Funds,                                                  whole and to take decisions at a
Private Equity Firms & Venture                                                     project level!
Capitalists (any Asset Management

    Equity Valuation Fundamentals
    Wealth Maximization through Valuation                                                              

What is Wealth Maximization?
Strategies are made in the boardroom while their results are declared by the secondary market! Wealth Maximization
deals with making business decisions that create „wealth1‟ for shareholders instead of just maximizing Profit/EPS

                                                                Step 3 - Adapt                                        through
                                                                expectations in                                  „Valuation driven‟
                                Step 2 - Quantify               Business Decisions                                decision making
                                expectations through
                                                                Business decisions must be
Step 1 - Understand             Valuation
                                                                aligned to expectations so as to
Expectations                    Valuation is the process of     maximize wealth. Managers
                                capturing expectations with     must ask themselves whether a
Expectations are difficult to                                   project will add wealth to the
                                the „most likely‟ scenario in
capture as they are not only                                    firm as a whole
                                terms of business performance
affected by sentiments but
also fundamental performance

Note: Today, many companies believe that „Value Creation‟ for
customers & society is as relevant as maximizing shareholder
returns. However, these two goals may result in friction at         1 Wealth refers to
                                                                                     the total wealth created for shareholders through capital
times leaving the shareholders to prioritize!                                appreciation + dividends a.k.a. Total Returns to Shareholder (TRS)   3
    Equity Valuation Fundamentals
    Valuation Approaches                                                                           

Why not have just one approach?
The idea is to capture all dimensions that a investor may be concerned with. Unfortunately, no single valuation
methodology is „complete‟ and hence two or more approaches are necessary to arrive at a „fair value range‟

Income based                                  Market based                               Asset based
Income based approaches aim to discover       Market based approaches aim to capture     Asset based approaches aim to value a
value of a firm through its income metrics    market sentiment while also taking into    firm by valuing its assets on a carry
like Net profit or Free Cash Flows etc.       account peer comparison.                   value, replacement value or liquidation
E.g. DCF Valuation, Edwards Bell Ohlson       E.g. Trading & Transaction Comparables     value basis
(EBO) model etc.                              i.e. Relative Valuation                    E.g. Liquidation value approach,
Pros                                          Pros                                       Replacement cost method and Book Value
 Cuts through accounting variances &          Captures market sentiment                Pros
    earnings abnormalities while also          Very quick & easy to apply                Works best for distressed & loss
    considering Macro level implications to    Works best between quarters                 making companies
    determine fair value of the firm           Results are very easy to explain/pitch    Works best in the downturn
 Considers Time value of Money               Cons                                        Gives „worst case scenario‟ value (i.e.
 Most detailed & scientific                   Does not work well for startups             in a way intrinsic value)
 Provides intrinsic value                     Has a tendency to overvalue stocks in     May also be used for target screening
 Used as a basis to determine whether            bullish markets and undervalue in         as first step in the M&A lifecycle
    valuation is „stretched‟                      bearish ones                           Cons
Cons                                           Sways with the market as there is no      Severely undervalues profit making
 Fails to capture sentiment                      anchor or „intrinsic value‟               companies by not capturing market
 Extremely data intensive                     Many believe that the approach is           sentiment or business performance
 A forecast, by virtue, brings with it an        responsible for bubbles                 Fails to capture market sentiment
    element of uncertainty                                                                                                            4
    Equity Valuation Fundamentals
    Valuation Methods                                                                                      

Discounted Cash Flows             Trading Comparables                 M&A Valuation                       Other Methods
DCF Valuation aims to discover    a.k.a. Relative Valuation, aims     Although not an entirely            Other methods some of which
the „Intrinsic Value‟ of a        to determine valuation by peer      different methodology it deals      are „academic‟ in nature and
company by estimating             comparison and hence                with judging the feasibility of a   hence best left in books.
present value of future cash      captures market sentiment           merger/acquisition using            However, theory is the basis of
flows.                            Sub Methods:                        slightly modified techniques        practice hence they deserve a
Sub Methods:                       - Equity & Enterprise              Methods Used                        good read!
 - Enterprise valuation (FCF/F)   Multiples                            - Accretion/Dilution Analysis       - First Chicago Approach
 - Equity method (FCFE)           Pros:                               (measures whether EPS                - Contingent Claim Valuation
 - Economic Profit Model           - Capture Market Sentiment         increases or decreases post          - Edwards, Bell & Ohlson model
 - APV approach                    - Quick & Easy to apply            deal)                                - Dividend Discount Model2
Pros:                              - Works between quarters            - Transaction Comparables           - Liquidation Value approach2
 - Very scientific and detailed   Cons:                               (scrutinizes historical              - Replacement Cost approach2
 - Normalizes accounting noise     - In the real world, there is no   transactions for „deal               - Sum Of The Parts Valuation2
 - Provides intrinsic value       such thing as a perfectly           premium‟ paid on similar               (SOTP ) a.k.a. Multi-business
Cons:                             comparable company                  acquisitions)                          Valuation
 - Sensitive to many factors       - Valuation is always biased as     - LBO modeling (measures the
most of which are at the          there is no benchmark               „IRR‟ available for equity          Remark: Modern theory &
discretion of the analyst.        valuation of the company in         contributors post debt              practice is a result of great
 - Does not work well between     question                            repayment)                          amount of invaluable
quarters                           - Bull markets lead to more                                            contributions made by several
 - Fails to capture sentiment     bullish valuation and vice-versa    Remark: These are the most          academicians on the subject.
                                                                      popular techniques used for         Some of these methods were
Best Suited For: The long         Best Suited For: Highly volatile    valuing M&As and hence there        part of the evolution chain and
term. Acts as an anchor for       companies, cyclical companies.      is little choice available to       that was the only role they ever
other methods                     Suited for the short term           discuss pros/cons                   played!      2 briefly discussed ahead   5
    Equity Valuation Fundamentals
    Is there a „Best‟ method?                                                                            

Simply Put                  Investment Horizon & Valuation                                         Investment Type & Valuation
No. There is no „Best‟      Investment Horizon i.e. Short Term or Long term                        Investment type
method. Apart from the      A short term (let‟s say less than one year) investor Is typically      i.e. Strategic or Financial
pros/cons, each method      interested in determining fair value between quarterly results.        Financial investments are made in
is designed to suit:        Although DCF provides an intrinsic value, in the short run, share      the secondary market where one
 - an investment horizon    prices may be very volatile and DCF will not help such an investor     relies on secondary data with the
 - an Investment type       in any way. Hence, Short term investors a.k.a. „speculators‟ must      idea of liquidating the investment at
 - market conditions        rely on trends, sentiments and news to determine valuation.            some point in the horizon instead of
 - a specific sector3       These factors are best captured in the Comparables Method (i.e.        generating regular returns from the
 - a specific scenario3     Relative Valuation).                                                   capital itself. On the other hand,
                                                                                                   Strategic investments are the ones
                                                                                                   made as part of „Corporate Finance‟
The best way out            Market Conditions & Valuation                                          and hence data availability is not an
                                                                                                   issue and the investor may go for
The best approach is what   Bullish & Bearish Markets call for different valuation strategies
                                                                                                   primary research when more data is
many call the “Valuation    and hence different methodologies. In bullish markets, many shift
                                                                                                   required. Needless to say, the funds
Football Field” a.k.a.      from DCF to Comparables in the pretext that “DCF fails to
                                                                                                   involved & research carried out is
“Triangulation”. This       capture that the market as a whole has moved to a higher level”.
                                                                                                   more intense. E.g. Project Appraisal
involves determining fair   However, they fail to recognize that without DCF, the valuation is
                                                                                                   Which method for which type?
value using all relevant    „floating‟ and is no longer tethered to an intrinsic value. The
                                                                                                   For a Financial Investment one may
approaches followed by      opposite prevails in case of bearish markets, when analysts swear
                                                                                                   choose a Market / Income / Asset
drawing an inference in     by DCF, now claiming that Comparables understate valuation.
                                                                                                   based valuation approach.
terms of a fair value       Bottom-line: It is at an inflection point, that the truth about such
                                                                                                   However, in case of strategic
range. This approach also   theories is exposed. Secondly, one cannot predict inflection points
                                                                                                   investments one must rely on an
helps in using one method   implying that, along with comparables an intrinsic value method
                                                                                                   Income based approach backed by an
to „sanitize‟ the other!    must always be used to see how far the tether can be stretched.
                                                                                                   asset valuation. 3 briefly discussed ahead   6
    Equity Valuation Fundamentals
    Which method is best suited: Public vs Private                                                       

Public Company Valuation                                               Private Company Valuation
Public Companies, by law, must provide audited financial results       It must be noted that , Private company valuation is driven by a
on a regular basis to the public at large. That apart, they also       strategic purpose like Private Equity, Joint Ventures and M&As.
„may‟ make available a host of other investor friendly information     For such purposes, traditional „financial investment‟ driven
in the form of industry trends, presentations, analyst meets &         methodologies will fail. Simply because, strategic transactions
conference calls. Secondly, Public companies get far more              are motivated by a „control factor‟ i.e. the power/authority to
coverage in the form of analyst reports, news, management              change business direction & strategies. This control commands a
guidance and interviews. All this makes the job of valuation an        premium over normal „trading driven‟ valuation approaches.
easier one. With such data availability it is easier to use any of     Hence, the Transaction Comparables approach (a.k.a. Precedent
the valuation techniques with a high degree of reliability. For such   Transaction Analysis or Deal Comps) is more popular & relevant
companies, any of the valuation methodologies discussed earlier        here. However, as for all scenarios, one must use other
may be used (also depending on the Scenario and sector)                approaches as well to determine a fair value range.

Which valuation method results in the highest Valuation?
Contrary to popular belief, the highest valuation is not driven by the method alone     In short, Transaction Comparables result in
but market conditions & the sector as well. In general, Transaction Comparables         highest valuations. While, in Bull markets
include a control premium and hence result in a higher valuation than other methods.    Comparables result in higher valuations than
Between DCF & Trading Comparables the results will vary depending on.                   DCF. The reverse holds true in Bear markets.
For E.g. When valuing a cement company, DCF is likely to result in a higher valuation   Unlike what many believe, DCF does not Inflate
as compared to Trading Comparables. However, the case reverses in the IT sector         value or result in highest value. The so called
where Trading Comparables seem to „inflate‟ value. This is caused because, the          DCF inflation is a result of errors & unrealistic
market at large believes that DCF fails to capture value in some sectors while          assumptions as a consequence of over-
Comparables fail in others.                                                             simplification of the approach
Note: The explanation above should be considered a „Rule of thumb‟ & not a tenet!
    Equity Valuation Fundamentals
    Which method is best suited: Scenarios-wise                                                           

Start-ups                          Matured Companies                      IPO Valuation
Startups are driven by far too     Matured Companies, have fairly         Although, for such situations it is best to use DCF as it
many factors to be captured by     predictable financials and hence       determines the intrinsic value, not many will want to use it as
simplistic valuation models.       DCF will result in a fairly reliable   it is likely to understate value as against Comparable valuation.
Their sensitivity to Economic,     valuation. However, the Dividend       Simply because, the idea behind an IPO is to raise maximum
Sector Specific and Company        Discount Model will also work          possible capital for a minimum dilution in equity! Hence most
specific factors must be           reliably, as matured companies         IPOs come out in bull markets where valuations are already
captured as far as possible to     have nominal expansion needs           „stretched‟ and Comparable Valuation will result in higher
reasonably value them. These       and hence a high dividend              values as compared to DCF, as a result of circularity involved
factors can only be captured       payout ratio along with                in such the approach. Consequently, you may notice that IPOs
with the DCF method.               predictability of growth rates.        are „demand driven‟ rather than intrinsic value led, as a result
                                   E.g. Large FMCG companies              many average companies get extraordinary valuations!

High Growth Companies              Cyclical Companies                     Distressed Companies
High growth companies have         Cyclical Companies, by virtue,         Distressed company valuation, is particularly tricky as the
drastically changing market        have a very high degree of             challenge lies in finding fair value and not the lowest value!
shares and hence it is very        uncertainty. Secondly, such            By distressed, we mean loss making companies or those that
difficult to compare them with a   companies are always on the            are restructuring their businesses by selling off „toxic assets‟
benchmark, making comparable       radar for news & management            and toning down capital structure. Traditional valuation
valuation difficult and leaving    comment both of which are              approaches fail miserably as a result of the uncertainty
one to go with the DCF             immediately reflected in               involved and this is where Liquidation Value & Replacement
approach.                          Comparables. On the other              cost method come to the rescue. Liquidation Value measures
E.g. Telecom companies             hand, DCF may have to wait for         return from selling off or liquidating the assets while
                                   a quarter or more to reflect a         Replacement Cost measures the opportunity cost of setting
                                   change. E.g. Sugar Companies           up a business. E.g. Many Textile Companies                          8
    Equity Valuation Fundamentals
    Which method is best suited: Sector-wise                                                         

Basic materials                   IT & ITes                          Telecom                           Healthcare / Hospitality
Steel & Cement represent          IT & ITes companies have very      The Telecom sector, has rich &    Like telecom, these sectors
basic/building materials. The     complicated business models        abundant data availability to     too can be very easily broken
sectors are cyclical (driven by   where revenues are scattered       generate very reliable numbers    down into a logical flow of
expansion cycles). Being          & unpredictable, face constant     over a 3-5 year horizon and the   numbers resulting in a reliable
cyclical, in normal/bullish       threat of protectionism and so     business model can be very        medium-long term forecast.
scenarios Comparables             one simply cannot have a           easily broken down into a flow    Hence DCF is a rational choice.
approach is best suited.          reliable long term forecast.       of numbers. For this reason it    However, asset based
However, in downturns it is       Hence Comparables is chosen        is recommended to use the         approaches are a must in
better to shift to Asset based    over DCF by most. However,         DCF approach. However, many       bearish markets to determine
approaches to reflect             we suggest the use of DCF in       analysts use Comparables to       „worst case scenario‟ valuation
maximum downside potential.       very bullish/bearish markets.      provide short term targets.

Core Sectors                      Retail                             Conglomerates / Multi Businesses
Infrastructure, Power and Oil &   Although appearing to be           SOTP valuation, is not an altogether different valuation
Gas together form the Core        simple, this is one of the most    methodology but just a combination of two or more traditional
Sector. These sectors are         complicated sectors to value.      ones. The idea being, in case of a multi-business firm, certain
primarily driven by government    The complexity is a result of      business units may be better off valued using DCF while others
policy and funding, the details   distant breakevens, multiple       may be valued using Comparables while some maybe valued with
of which are clearly made         formats, complex funding           an asset based approach. The result of each, shall be summed-up
available. Having distinct        provisions (debt/lease/cash)       to determine the value of the firm as a whole. Sum Of The Parts
drivers along with rich data      and „not-so-easily-quantifiable‟   (SOTP) can be used for multiple product lines, multiple business
availability make it a perfect    demand. This leads to a hybrid     units or multiple subsidiaries. The choice of valuation for each
DCF candidate. Asset valuation    valuation approach often called    unit must be based on strong rationale, rather than gut feeling
should be used as a support.      „SOTP‟ Valuation!                  (as discussed for the sectors above).                               9
Equity Valuation Fundamentals
Valuation FAQs: General                                                                   

                      Why do share prices move up ?
Why do Share Prices
                      There are two broad factors affecting share prices
    Move up?
                      1. Fundamental performance of the company - Growth and quality/sustainability of Cash flows,
                         excess return over cost of funds (a.k.a. Economic Profit or EVA™)
                      2. Market Sentiments – Market sentiments may be influenced by overall performance of the
                         Economy, Institutional holding, Government policy, Sector performance, Promoter holding,
                         Management quality etc.
                      The points above can be combined to suggest that Share prices will move up only when
                      performance (fundamentals) is greater than expected returns (sentiments)
                      Or as Mckinsey calls it ‘Running faster than the expectations Treadmill’

                      Can we forecast sentiments ?
 Can we Forecast      No. It is like asking how many people will want to buy/sell a stock at a given point. As mentioned
   Sentiments?        above there are lot of factors affecting sentiments and it is very difficult to understand how the
                      market will react to each such factor. Although, Technical analysts claim to do so, it is yet to be
                      proven and therefore it remains a controversial subject

                      What about market expectations ?
What about market     Unfortunately, sentiments drive expectations. At best, a snapshot of market expectations can be
 expectations ?       taken by getting Consensus estimates (available on popular websites /databases like Bloomberg,
                      Thomson-Reuters etc.) However, one cannot forecast this aspect and hence beating the street
                      remains the biggest challenge for managers!
 Equity Valuation Fundamentals
 Valuation FAQs: General …[Contd]                                                            

                         Any proof that other methods of valuation work ?
 Any proof that other
                         Yes. According to a study conducted by Tom Copeland (Co author of a bestseller, Former Chicago
   methods work ?
                         University Professor, Former Partner at McKinsey & Co. and currently Partner - Monitor group) a
                         correlation of 80% between DCF and Current Market Price exists!

                         Wealth Maximization or Profit Maximization ?
Wealth Maximization or
                         Profits are not the only source of Financial rewards to a shareholder. She may also benefit from
 Profit Maximization?
                         capital appreciation as a result of selling her stocks at a higher price. As a result the Profit
                         Maximization motive fails in comparison to Wealth Maximization (includes also sources of wealth)

                         How does a company create wealth ?
 How does a company      To achieve this goal the company must strive to generate a return over its cost of funds while
   create wealth?        beating (or at least matching) market expectations ! The spread between the returns over funds
                         and cost of such funds is called Economic Profit.

                         What does Economic Profit mean ?
 What does Economic      A.k.a. EVA™ In the equation below, ROIC represents the return on capital while WACC reflects the
   Profit mean?          cost of the same. For a firm to grow and reward its Claimholders its Return on Funds must always
                         be higher that the cost. Economic Profit = (ROIC – WACC ) x Invested Capital

                         So When does DCF come into the picture ?
So when does DCF come    A Discounted Cash Flow Valuation aims to arrive at the ‘Intrinsic Value’ of a company by
    into the Picture?    discounting the forecasted ‘free’ cash flows at a rate = cost of generating such cash flows.           11
  Equity Valuation Fundamentals
  Valuation FAQs: DCF                                                                                                          

                              Why Discount Cash Flows ?
Why Discount Cash Flows
                              As discussed, the goal of a company is to generate wealth for its owners (i.e. Shareholders) and not
    and not Profit?
                              Profit Maximization. The method is based on the belief that ultimately what can be distributed to
                              Shareholders is Cash and hence the phrase ‘Cash is King’.

                              Why is it considered more scientific ?
Why is it considered more
                              Shareholder wealth will be maximized as a result of cash inflow through cash/stock dividends and
                              capital appreciation. However, paying dividends implies that the company has lesser internal cash
                              to reinvest as a result it will need to borrow/raise more, causing the Share price to come down by
                              that much. On the other hand Capital appreciation, in the long run is related to company
                              fundamentals. This also explains why growing companies pay less or no dividends as compared to
                              stable/mature ones.

                              Why not discount dividends4 ?
    Why not discount          Firstly, Not all companies pay dividends. Secondly, dividends reduce internal cash resulting in a
      dividends4 ?            reduction in its Share price (Although for mature companies, as a result of lesser reinvestment
                              needs Dividends are ‘believed’ to increase Shareholder wealth).

                             4 Dividend Discount Models, although not very popular with practitioners, have their own place when the situation is ‘right’. For e.g.   12
                            they are popular with investment banks & research firms when it comes to valuing banks and companies that have high payout ratios
  Equity Valuation Fundamentals
  Valuation FAQs: DCF…[Contd]                                                                    

                            Will DCF give an accurate value per share ?
Will DCF give an accurate
                            Value per share as arrived at using DCF is just as good as the quality of Forecasts. Although there
     Value per Share?
                            are several approaches to scientifically forecast the performance one must remember that a
                            forecast, by virtue is based on certain assumptions, which are specific to every company/analyst.
                            Although companies often aim to standardize such assumptions, they remain just that !

                            Is DCF the best method to arrive at Fair Value ?
Is DCF the best method to   As mentioned earlier, there is no ‘best’ method. Share Prices, in the long run will (and must) revert
    arrive at Fair Value?   to fundamental performance of the company in question. However, prices are also driven by
                            sentiments which are not captured in DCF. This is where Comparables come to the rescue, it not
                            only captures sentiments but is also better suited between quarterly results. Hence DCF and
                            comparables are said to be complimentary! The process of triangulation is hence recommended

                            Should we forecast cash flows directly ?
Should we forecast cash     No. Cash Flows are the most important component within the DCF equation and hence the quality
    flows directly ?        of forecasts will ultimately decide the reliability of the Intrinsic Value thus arrived at.
                            • Although Academicians suggest that cash flows must be directly forecasted, such a practice will
                              yield unreliable results in real world situations.
                            • The lifeblood of a company is Sales and hence it is a very critical item while forecasting cash flows
                              Secondly a detailed COGS & Capex build up cannot be ignored. Put Simply, Free Cash flows are an
                              outcome of a detailed Financial-cum-business model. Directly forecasting them will result in little
                              credibility to the final output !
  Equity Valuation Fundamentals
  Valuation FAQs: DCF…[Contd]                                                                 

                           What is Discounting? And why must it be used?
  What is Discounting?
                           Discounting flows from the concept of ‘Time Value of Money’. Put simply, it means the value of
And why must it be used?
                           money deteriorates with time as a result of risk/uncertainty. To determine ‘Present Value’ of a
                           future cash flow we must discount it by the cost of funds raised to generate the cash flows.

                           How is the discount rate calculated ?
How is the Discount rate   The Estimation (not calculation) of the discount rate firstly depends on the type of DCF method
      calculated ?         used, following which, one must estimate the opportunity cost of the capital contributors (i.e.
                           depending on the type of DCF method used the discount rate will vary). Following the principle of
                           consistency one must identify all contributors to the specific cash flow model

                           Methods within DCF ?
 Methods within DCF ?      Contrary to popular belief, all 4 methods within DCF must result in the absolutely same Value per
                           Share. However, capital structure and beta prevent this from happening.
                           Therefore, it is futile to compare/use two different DCF approaches simultaneously.
                           1. Enterprise DCF – The method aims to forecast operating cash flows for firm (i.e. available to all
                              capital contributors), subtract the Present Value of all Non-Equity items and add back all non-
                              operating excess cash/cash equivalent items. The discount rate hence must be the WACC.
                           2. Equity DCF – Theoretically the easiest of all, but practically the method poses several challenges
                              and hence loses out to the Enterprise method in popularity. As the name suggests, Cash Flows
                              to Equity holders are calculated and hence discount factor is the ‘Cost of Equity’
                           3. Adjusted Present Value – Recommended for use in Special situations like LBOs
                           4. Economic Profit Method – Uses EVA™ to‘validate’ the Enterprise DCF approach                      14
 Equity Valuation Fundamentals
 Valuation FAQs: Comparables                                                                           

                          What are multiples ?
  What are multiples?     Multiples are ratios used to gauge the degree to which a stock is over/under valued. By themselves,
                          they are of no significance. However, when compared to a set of ‘similar’ companies a lot may be
                          revealed. As mentioned earlier they are used both in Trading and Transaction comparables .
                          • Multiples are of two main types Equity and Enterprise each having its own place
                          • Types of Equity multiples P/E, PE/G, M/B (or P/B) etc.
                          • Types of Enterprise Multiples EV/Sales, EV/EBITDA, EV/EBIT etc.
                          • For Every multiple the numerator must be related to the broader market while the denominator
                            must be one that reflects a relationship between the company fundamentals and the appropriate
                            numerator. To make things simpler, lets consider the most popular of all multiples – P/E. Now, the
                            numerator is the Market capitalization or Market Value per share i.e. the market value of equity
                            and hence the denominator must reflect what is available to equity claimholders – Net Profit.

                          How are Multiples used ?
How are Multiples used?   A sector average (or weighted average ) is calculated as a benchmark on a Last twelve month
                          (LTM) or ‘Forward’ basis, to which the company in question is compared, thus determining
                          whether it is over/under valued. 5

                          Are they more popular than DCF ?
Are they more popular     Yes. The approach, as a result of it’s (believed) ease of application, flexibility and reach is far
      than DCF ?          more popular than any other. However, to make it real world ready it needs some serious
                          research and enhancements to it’s popular avatar!                             5 The explanation was a over-

                                                                                                       simplification of the actual process
Equity Valuation Fundamentals
Recommended Reading                                                                   

Recommended Reading
 1. Mckinsey Valuation 4th Edition – Tim Koller, Marc Goedhart & David Wessels
 2. Financial Valuation – James R. Hitchner (with contributions from 25+ Authors)
 3. Investment Fables – Aswath Damodaran
 (Note: Although, „Investment Fables‟ is a very well written „study‟, we do not recommend Damodaran‟s valuation
   approach as we believe it is far too simplistic & fundamentally naive for real world application)

 Recommended Articles
 1. The expectations treadmill – Richard F.C. Dobbs, Tim Koller (Mckinsey Quarterly)
 2. Do Fundamentals or Emotions drive the Stock Market? – Tim Koller, Marc Goedhart & David Wessels (Mckinsey
 3. Equity Analysts: Still too bullish – Marc Goedhart, Rishi Raj & Abhishek Saxena (Mckinsey Quarterly)
 4. The irrational Component of your Stock price – Marc Goedhart, Bin Jiang & Tim Koller (Mckinsey Quarterly)
 5. New developments in valuation – An interview with Tom Copeland
Equity Valuation Fundamentals
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