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					Investment Principles and Equity Valuation

Investment Principles

Premises for Valuation
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Efficient Market Theory Almost all the time should not be confused with always. Ultimately, human beings decide price of assets in the market and they are subject to greed and fear. At times, they price assets away from their intrinsic value.
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Market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism. Intelligent investor is a realist, who sells to optimists and buys from pessimists. BG

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However, prices of assets will converge with their intrinsic value over a period of time. To make money in the market, get greedy when others are fearful and be fearful when other are greedy. WB

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Investment Principles
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Stock represents ownership interest in an actual business, with an underlying value that does not depend on its share price. Stocks are not worth buying at any price. Return on every investment is a function of its present price. The higher the price you pay, the lower your return will be. No matter how careful you are, one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on “margin of safety” – never overpaying, no matter how exciting an investment seems to be –one can minimize odds of error. Become a critical thinker, take no wall street “fact” on faith, invest with patience, develop discipline and courage, refuse to let other people’s mood swings govern your thoughts.

Investment Principles
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Obvious prospects for physical growth in a business do not translate into obvious profits for investors. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries. Control the self-defeating behavior that keeps most investors from reaching their full potential. How your investments behave is much less important than how you behave. Intelligent investing has nothing to do with IQ or SAT/GMAT scores. It is about being patient, disciplined and eager to learn.

Investment Principles
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An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
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Thorough analysis First safety Then, return

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Minimize the odds of suffering irreversible losses. Maximize the chances of achieving sustainable gains.

Investment Principles
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Bull markets have a number of well-defined characteristics in common:
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Historical high price level High P/E ratios Low dividend yields as against bond yields Many offerings of new common-stock issues of poor quality.

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Bear markets also have a number of well-defined characteristics in common:
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Historical low price level Low P/E ratios High dividend yields as against bond yields People are not willing to touch stocks. General fear among investors about stocks.

Investment Principles
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Focus on buying an existing business Buy simple businesses in industries with an ultraslow rate of change
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We see change as the enemy of investments. So we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs. W. B.

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Buy businesses with a durable competitive advantage
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The key to investing is not assessing how much an industry is going to affect society or how much it will grow but rather determining the competitive advantage of any given company and above all, the durability of the advantage. W.B.

Investment Principles
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Focus on ROI. Look for businesses replacing capital with creativity and imagination Buy businesses at big discounts to their underlying intrinsic value
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The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. The bigger the discount to intrinsic value, the lower the risk. The bigger the discount to intrinsic value, the higher the return.
•

Benjamin Graham

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Better to buy copycat than an innovator Undertake few bets, big bets and infrequent bets

Investment Principles
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A lot of great fortunes in the world have been made by owning a single wonderful business. If you understand the business, you do not need to own very many of them. Outstanding investment opportunities are rare..go at it when it comes around, and put a huge portion of your wealth into it. Think of investment as though you have a punch card with 20 holes in it. You have to think extremely hard about each one, and in fact 20 (in a lifetime) is way more than you need to do extremely well as an investor. Exist is as critical as entry

Investment Principles
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It requires a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it.
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Nathan Mayer Rothschild

Understanding Financials and Ratios

Business flow

Source - Investopedia

Sources of funds


Sources of long term funds
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Financing by Banks and Financial Institutions Capital Market Products
   

•

Sources of short term funds
 

Equity Debt Preference shares Hybrids

Financing by Banks and Financial Institutions Money Market Products
    

Commercial papers Public deposits Inter-corporate deposits Bill discounting Factoring

Equity
Equity capital is the risk capital, which represents ownership in a business entity.
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Company’s perspective:
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No fixed obligation of funds on equity. It is perpetual in nature.

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Investors’ perspective:
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Dividend and capital appreciation, if any. No fixed return. Voting right. Claim over the residual assets at the time of liquidation of the company (last claim).

Equity features
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Face value per share Market value per share and Market capitalization Book value per share = Net worth/ number of outstanding shares. New worth is equal to the share capital + reserves and surplus other than the Capital Reserves. Earning per share (EPS) = Profit after tax / number of outstanding shares. Dividend per share (DPS) Dividend payout ratio = DPS/EPS Price earning ratio (P-E ratio) = Market price/ EPS

Debt
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Debt provides the business with the capital bearing a fixed/floating cost obligation. Debt instruments represent lending rights not the ownership rights. Debt can be secured or unsecured. Debt owners have :
– – –

Interest – Payment of interest is an obligation on the company. No voting right. Claim over the assets of the company before the equity holders. Different debt owners would have different priority claims on the assets of the company at the time of liquidation.

Debt features
      

Face value/ Par value Issue price (at face value or at discount/premium to the face value) Redemption value (at face value or premium/ discount to the face value) Terms of the redemption – Bullet or otherwise Rate of interest (Coupon) – Fixed or floating Maturity of the instrument Can we have perpetual debt?

Variety in the debt market
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Step up bonds. Step down bonds. Amortization bonds. Perpetual Bonds (consol bonds). Principal protection Bonds. Payment in kind bond (PIK bonds). Deep discount bonds. Floating rate bonds. Treasury Inflation protection securities (TIPS).

Preference shares


Preference share holders have :  Equity like features
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Dividend, which is fixed and paid from profit. Dividend is not an obligation on the company. Tax treatment at par with ordinary equity. Fixed tenor of the instruments. Fixed dividend and paid before the equity holders. At liquidation, their claim is prior to the claim of ordinary equity holders. No voting right originally. But acquire the voting rights in certain circumstances.

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Debt like features
s s s s

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Preference shares are called quasi equity as they behave partly like shares and partly like debt instruments.

Hybrid instruments
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Convertible bonds are bonds to be converted into equity of Issuer Company. Important considerations in convertible are:
1. 2. 3. 4. 5.

Whether conversion is compulsory or optional? If it is optional, in whose hands? What is the price at which equity shares would be issued? Is it a fixed price or floating price? If it is floating price, what is the reference benchmark for determination of conversion price? What time will the conversion take place?



Preference shares can also be convertible like debt instruments.

Sources of short term funds


Commercial papers
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Issued at discount Unsecured in nature Generally issued at par Unsecured in nature



Public deposits
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Inter-corporate deposits Bill discounting – Financing against the commercial bills.
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Banks can discount the commercial bills (both demand and usance bills). Banks can approach other banks and institutions for rediscounting of the bills, discounted by them.

Sources of short term funds


Factoring – Sell off the commercial bills.
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Factoring is a variant to the bill discounting. It results in the sale of the bills to the other party. This sale of bills may be with recourse or without recourse.

Considerations for sources of funds
Cost and tenor of funds s Business risk s Control considerations s Tax considerations s State of the market
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Uses of funds
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Fixed Assets – Land and building – Plant and Machinery – Others Working Capital – Raw Material – Work in progress – Finished goods – Cash Investments – Various avenues of investment

Basic Concepts of Accounting
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Entity Concept Going Concern Concept Conservatism Concept Dual Aspect Concept (Asset = Lib. + equity) Accounting Period Concept Accrual Concept Realization Concept Matching Concept

Simple Illustration – ABC Inc.
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Promoter contributes $500,000 as equity. ABC pays $100,000 as deposit for hiring office premises. ABC buys furniture and fixtures for $300,000. ABC buys merchandise worth $300,000 on credit. ABC sells merchandise costing $100,000 for $120,000 on cash basis. ABC sells merchandise costing $80,000 for $100,000 on credit. ABC pays establishment expenses of $5000 in cash. ABC pays $9,000 as rent in cash. ABC depreciates the Furniture and Fixture by $10,000.

ABC Inc. B/S.
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Liabilities + Equity
Capital – Reserves and Surplus – Trade Credit  Total
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500,000 16,000 300,000 816,000 206,000 100,000 290,000 120,000 100,000 816,000

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Assets
Bank Deposit – Premise Deposit – Furniture and fixture – Merchandise – Debtors  Total
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ABC Inc. P/L
s

Revenues
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220,000
120,000 100,000

Cash sale Credit sale

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Expenses
– – – –

204,000

Merchandise cost 180,000 Establishment Exp. 5,000 Rent 9,000 Depreciation 10,000

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Profit

16,000

Important Accounting Rules
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Every transaction has a bearing on at least two accounts in B/S. Irrespective of the transaction B/S identity is preserved i.e. Assets = Liab. + Equity. Transactions, which do not result in a revenue or expense, have no bearing on the P/L (or Reserve and Surplus).
Balance sheet provides readers with the static picture of the business on a specific day. Profit and loss account (P/L) provides a dynamic picture of business over a period of time.

 

A typical Balance Sheet
Liabilities (Sources of Funds)


Assets (Uses of Funds)


Share Capital
   

Fixed Assets
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Authorized Capital Issued Capital Subscribed Capital Paid up capital
 

Land and building Machinery Fixture and Fittings Others

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Preference share capital Reserves and surplus
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Investments Current Assets, Loans and Advances
   

Revenue reserves Capital reserves

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Secured Loans Unsecured Loans Current liabilities and Provisions
   

Inventories Sundry debtors Cash and bank balances Loans and advances



Bills Payable Sundry Creditors Advance Payments Various Provisions

Miscellaneous Expenditures and losses
  

Preliminary expenses Discount allowed on issuance of securities Other capitalized expenses

Profit and Loss Account
Revenues (Net Sales) Less cost of goods sold Gross Profit Less Operating expenses Operating profit Add (deduct) non operating surplus (deficit) Profit before depreciation, interest and taxes (PBDIT) Less Depreciation Profit before interest and taxes (PBIT) Less Interest Profit before taxes (PBT) Less taxes Profit after taxes (PAT)

First step to valuation

Simple P/L (in USD)
Net Sales 10,000,000 COGS 6,000,000 Gross Profit 4,000,000 Other Expenses 2,000,000 Operating Profit 2,000,000 Taxes @ 30% 600,000 PAT 1,400,000 Share capital: 2,000,000 shares of $1 each. Would you buy this business?

Profitability check
Gross profit margin (40%) s Operating profit margin (20%) s Net profit margin (14%)
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Forgot to tell you that keeping everything else constant, debtors in the books of company have gone up by $2,000,000.

Cash flow statement
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Generating Cash is critical for a firms’ long term survival. P/L and B/S do not focus on cash flows. Cash flow of a firm may be reflected as follows: •Looking at net cash flows could be deceptive •One needs to analyze each of the cash flow streams independently
Picture source – Investopedia

Cash flow statement
sObjective

is

to focus on sustainable and recurring cash flows sIdentify and adjust for non recurring/extra ordinary items

Picture source - Investopedia

Tata Steel’s cash flows in 07-08
Cash flows Net cash flow - operating activity Net cash - investing activity Net cash - financing activity Net inc./dec. in cash and equivalent Cash and equivalent - begin of year Cash and equivalent - end of year Mar ' 08 6,254.20 -29,318.58 15,848.07 -7,216.31 7,681.35 465.04

Source – money.rediff.com

Liquidity check - exercise
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Revenues 1st month : $100M Expenses 1st month : $70M 1st month expenses include purchase of a second hand car for $10M Revenues 2nd month : $150M Expenses 2nd month : $75M 2nd month revenues include sale of shares for $20M and expenses include purchase of shares for $10M Revenues 3rd month : $125M Expenses 3rd month : $270M 3rd month revenues include sale of car purchased in 1st month for $10M and expenses include purchase of a new car for $20M and purchase of a house for $200M Pl prepare cash flows for three months independently and consolidated cash flow for the quarter.

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Note : M stands for 1,000 and all the transactions are in cash

Liquidity check
1st month Operating cash flows : +$40M (100 – 60) Investing cash flows : -$10M Financing cash flows: Nil Net cash flows: +$30M s 2nd month Operating cash flows : +$65M (130 – 65) Investing cash flows : +$10M (20 – 10) Financing cash flows: Nil Net cash flows: +$75M s 3rd month Operating cash flows : +$65M (115 – 50) Investing cash flows : -$210M (10 – 20 - 200) Financing cash flows: ? Net cash flows: -$145M (65-210) s Consolidate Operating cash flows : +$170M (40+65+65) Investing cash flows : -$210M (-10 + 10 - 210) Financing cash flows: ? Net cash flows: -$40M (30+75-145) or (170-210)
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Liquidity check
Liquidity refers to the ability of the firm to meet its obligations in short run. s Does the company have sustainable positive operating cash flows? s Do current assets show continuous coverage of current liabilities with good margin ? s Do current assets (excluding inventory) show continuous coverage of current liabilities with good margin ?
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Simple P/L (in USD)
Unleveraged Leveraged (1:1) Net Sales 10,000,000 10,000,000 COGS 6,000,000 6,000,000 Gross Profit 4,000,000 4,000,000 Other Expenses 2,000,000 2,000,000 EBIT 2,000,000 2,000,000 Interest 100,000 EBT 2,000,000 1,900,000 Taxes @ 30% 600,000 570,000 PAT 1,400,000 1,330,000 EPS $.70 $1.33 s Leverage does magic in terms of improving EPS and Return on equity. s Let us make it leverage 3:1 (debt/equity), EPS turns to $2.59. s Appreciate that nothing comes free.. Accordingly, enhanced leverage increases the financial risk in the firm. s Logically, should not we look at return (EBIT) on capital employed irrespective of mode of financing ? That no. is same for both the firms.

Financial risk check
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Leverage is equally important to both lenders and equity owners Financial leverage refers to the use of debt component in Capital Structure Important checks are:
– – – –

Coverage of debt by equity Coverage of interest by EBIT Coverage of interest by operating cash flow Coverage of debt service by operating cash flow

Forgot to tell you that company also has revenue reserves of $2,000,000.

Simple P/L (in USD)
Net Sales COGS Gross Profit Other Expenses EBIT Interest EBT Taxes @ 30% PAT EPS ROE
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No reserves 10,000,000 6,000,000 4,000,000 2,000,000 2,000,000 2,000,000 600,000 1,400,000 $.70 70%

With reserves 10,000,000 6,000,000 4,000,000 2,000,000 2,000,000 2,000,000 600,000 1,400,000 $.70 35%

Should not we look at return on Equity (both capital + reserves) rather than only capital. Indeed, including the debt if any…which takes us to Return on Investment employed in the business.

Return of capital check
Return on Equity s Return on Investment s Return to be taken as EBIT to make it free from influence from financing decision
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Efficiency check
Inventory churn s Receivables churn s Fixed Assets churn s Total Assets churn
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Valuation parameters
Price Earning Ratio s Market Price to Book Value Ratio s Beta of a stock and cost of capital
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Cost of equity Cost of debt

Coloring financials
      

True and fair view…not essentially a correct view What is critical is consistency and not a specific methodology of accounting Past financials help you understand revenues/cost dynamics and assets/liability dynamics Future, anyway, is uncertain Work of an analyst starts when work of CA is over Management discussion and notes to accounts are more important than accounts themselves Closely scrutinize off-balance sheet items (financing , liabilities – guarantees, MTM on outstanding derivatives etc.)

Coloring Financials
 

 





Accounting future revenues in the previous year. Postponing expenditure – Capitalization of the expenses like R&D expenses, Brand building expenses (Advertisements and sales force cost). Change in the depreciation policy Extra provisions in the good years and writing them back in the difficult years. Not providing sufficiently for the known and contingent liabilities. Revaluation of assets to create impression of hefty reserves.

Valuation models

Valuation principles
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Ability to differentiate between value and price is key to success in investments Price is what you pay and value is what you get Understanding what an asset is worth and what determines that value is a pre-requisite for intelligent decision making Value must be supported by potential sustainable cash flows Valuation pre-supposes knowledge about the assets and the ability to estimate cash flows there from

Valuation models
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Net Asset Value Approach Discounted Cash Flow Valuation Relative Valuation Contingent claim Valuation These models can yield significantly different estimates of value. One needs to understand these valuation models in detail and pick right model to use in a specific situation. Even the best valuation comes with a substantial margin for error



Net Asset Value
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Net Asset Value is computed as: Total Assets – Current Liabilities & Provision – Total Debt – Contingent Liabilities

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Used in valuation of sectors such as Shipping, Real Estate and Airlines

Discounted Cash Flow Valuation
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Value of an asset is the present value of expected cash flows on it. We need future cash flows series and discount rate to arrive at DCF Valuation As Valuation time horizon is < Asset time horizon, we need terminal value. As significant value comes from terminal value, wrong estimations can infuse substantial error in valuation.

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Discounted Cash Flow Valuation
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Dividend Discount Models Free cash flow to equity Discount Model - Value equity based on free cash flows to equity (cash flow after debt payments and reinvestment needs) Free Cash Flow to Firm Discount Model - Value the entire business based on free cash flows to the firm (cash flow before debt payments and after reinvestment needs)

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Cost of funds
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Cost of equity to come from CAPM model: COE = Rf + β * (Rm –Rf)
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Cost of debt is always the marginal cost of borrowing. Cost of preference share will be observed yield - Pref. Div. / Market Price of Pref. Share. For non quoted equity/debt/preference shares, comparative values will be used. WACC is the cost of each component weighted by its percentage to total capital.

Determining Market Return-What historical period to considerlonger the better Higher leverage results in higher risk. Hence must be reflected in higher beta

Dividend Discount Models
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Value per share = Present Value of Expected Dividends Two fundamental inputs required-Expected dividends over the years and cost of equity for discounting. As per Gordon Model (constant growth model), value of Stock = DPS1 r-g
Where, r is the required rate of return and g is the growth rate in dividends.

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To reflect different stages of growth, we can expand the model to two stages or three stages Dividend Discount Model

Dividend Discount Models
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Useful tool of valuation only in case of limited number of stable high dividend paying companies

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Could undervalue companies that pay no dividends or low dividends.

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In a world where the entire amount available for distribution is not declared in dividends, FCFE is a better approach.

Free cash flow to equity Discount Models
 This is similar to the dividend discount models with the Free cash flows to equity substituting for dividends  Free Cash Flow to Equity is the cash flows to common stockholders

 Quick/Crude way to calculate FCFE
FCFE = EBITDA – Cash Interest – Cash Tax - Capex

– Change in Working Capital –– Principal Repayments + New Debt Issues

Free Cash Flow to Firm Discount Models
 In a leveraged world, Enterprise Value rather than equity value would be more relevant.  Accordingly, we can price the firm, using Free Cash Flows to Firm (FCFF) as future cash flows.  Free Cash Flow to Firm is the sum of cash flows to all stake holders - common stockholders, preferred stockholders and bondholders  Quick/Crude way to calculate FCFF
 FCFF = EBITDA – Cash Tax – Capex – Change in

Working Capital

Difficulties with Discount Models
• Future projections • Sensitivity of the result to the Terminal Value • Need to determine an appropriate discount rate

Relative Valuation
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Relative valuation is basically intuitive. We do this all the time in our personal life The relative valuation methods are an extension of natural habits of comparison to the field of finance. Value an asset looking at how the market prices similar/comparable assets.
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Trading Multiples Transaction Multiples

Relative Valuation – Trading Multiples
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Choose the appropriate valuation driver – Revenue, EBITDA, Net Profit, Book Value and Sector Specific Calculate the valuation multiple of the company’s peers (Domestic or International) Adjust the Multiple – Size, Operating/Net Margins, Growth Rate and ROCE Apply the multiple to the valuation driver of the company to derive the company valuation Widely used trading multiples
– – – –

Price/Earnings Price/Book Value Price/Revenue Sector Specific

Relative Valuation – Transaction Multiples Multiples at which the similar transactions happened in the industry form the basis for valuation s Does not necessarily provide the correct valuation s Generally used for negotiations
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Uses of Relative Valuation
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Highly useful for quick estimates of value Enables one to quickly identify potential baggers in a market Limited computations and assumptions. Reflects current market mood Good to appreciate parameters like max, min, average etc.

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Relative Valuation - Pitfalls
s

Inconsistent estimate of value - Key value parameters like risk, growth and cash flow potential are ignored

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Values move with market moods Vulnerable to manipulation and biases

Contingent claim valuation
s

Equity holders of the firm may be treated as having an option on the firm – either call or put, and so can be priced on option pricing basis.

Equity as an option
Position of stock holders and bond holders in terms of call option:
Stock holders
s

Bond holders
s

Stock holders have sold the asset to bond holders for loan amount, and stock holders own call option on the firm.

Bond holders own the firm, and Bond holders have sold a call option, on firm, to the stock holder.

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Equity as an option
Position of stock holders and bond holders in terms of put option:
Stock holders
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Bond holders
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Stock holder own the firm, Stock holders owe money to bond holders, and Stock holders own a put option on the firm.

Bond holders have landed money to the equity holders, and Bond holders have sold a put option, on the firm, to the stock holders.

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Important considerations
s

Valuation is objective:
– – –

s s s

Valuation is not timeless. It can change if circumstances or information change There is no precise estimate of value Complicated quantitative models need not mean the valuation is better

This may appear so but inputs required in the model are subjective. Inputs may be biased and there is a need to eliminate bias. Analyst’s stake in the firm under valuation might impact conclusions.

Corporate Actions and Valuation

Corporate actions
Cash dividend s Dividend in kind (stock dividend/bonus shares) s Stock split s Stock consolidation s Rights s Equity carve out s Buyback of shares
s

Corporate actions
Dividend decision


PAT money is available for equity holders. Following three things can be done with this money:
s Distribute s Retain

to equity holders as dividend.

the whole money and channelize that towards the business, if opportunities exist. part of the money and retain part of the money.

s Distribute

Corporate actions
Dividend decision
– – – –

Need of fresh funds in the company. Liquidity position of the company. Expectations of the shareholders. Management philosophy.

s

ROE along with retention ratio determines the growth rate of the earnings

Corporate actions
Bonus shares
–

This is another form of paying dividend and so bonus shares are also called stock dividend. Some fresh shares are given for the existing shares at no extra charges. Stock market prices fall down after bonus shares. In the books of company, general reserves become share capital (Capitalizing reserves). Shareholders’ proportionate ownership remains unchanged.

–

– –

–

Corporate actions
Split of shares
– – –

Each shares is split in more number of shares. Par value per share goes down. Stock market prices fall down Ex-split to adjust for increased number of shares. In the books of company, there is no impact other than the change in outstanding number of shares (become more).

–

Comparison between bonus issue an stock split
s

s

s

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Bonus Issue Par value of share remains same. A part of reserves is capitalized. Shareholders’ proportionate ownership remains unchanged. Book value per share, EPS and market value per share decline.

s

s

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Stock split Par value of share goes down. No capitalization of reserve takes place. Shareholders’ proportionate ownership remains unchanged. Book value per share, EPS and market value per share decline.

Corporate actions
Consolidation of shares
– – – – –

This is exactly opposite to the split of shares. Shares are consolidated and existing shares are exchanged for lesser number of shares. Par value per share goes up. Stock market prices go up immediately. In the books of company, there is no impact other than the change in outstanding number of shares (become less).

Corporate actions
Right shares
– –

– – – 

At the time of raising further capital, first offer is made to the existing share holders by the company. Additional shares are offered to existing share holders on priority basis to ensure that their shareholding does not get diluted. Shares are generally offered at a discount to market price of the share. Stock prices (Ex-rights) fall. In the books of company, capital changes. What about trading of rights on the exchange platforms ?

Corporate actions
Equity Carve-Out
– – – –

Offer for sale. Seller raises new funds. Seller generally maintains controlling interest in business. 100% equity carve-out is “divestiture IPO”

Corporate actions
Buyback of shares
Motives
s s s s s

Management thinks that the stock is undervalued. Excess cash and lack of profitable investment opportunities. As a confidence building measure. As a defensive strategy against a potential takeover To increase leverage in the company.
– –

For treasury operations. For extinction

Corporate actions
Buyback of shares
Modes of buy back
s

Fixed price buy back.
– –

Proportionate right is offered to the investors to sell their shares back to company. Buy back of shares is done generally at a price higher than the market price.

s s

Book built buy back Open market purchase

Corporate actions
Buyback of shares
– –

–

In the books of company, capital changes (it goes down). Buy back of equity shares in any financial year shall not exceed twenty five percent of the company’s total paid up capital and free reserves. D/E ratio should not exceed 2 after such buy back.

Thank you. Please feel free to reach me at:
manish@valueadvisors.co.in +91 98924 86751


				
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