Investing Across Equities and Fixed Income

Valuation of Equities :
A Practitioners Perspective

Presented By: Varun Dawar

Equity Investing- What is it all about?

A. No Company is good or bad.it is the Price at which it is available is good or bad.
B. Never attempt to make quick money on the stock market. Buy on the assumption that they could close the market the next day and not reopen it for five years.....

C. Be Fearful When Others Are Greedy and Greedy When Others Are Fearful...

Equity-Best Asset Class?

10 Year CAGR return of various asset classes (2000-2010) Gold very close to equities 7 out of 11 - 10 year periods have yielded double digit returns
18% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 15% 11% 17%

2000-2010
1998-2008

13% 12%

18% 16%

1996-2006
1994-2004

19%

8%
4%

1992-2002
1990-2000 1988-1998 1986-1996
Equities (BSE 30) Debt Crude Oil Gold Real NHB estate - Residex Shiller (India) Home Index (US)

3%

5% 6%
6%

12%

14%
16%

20%

1984-1994 1982-1992 1980-1990 0% 5% 10% 15%

19% 19%

24% 31% 29% 27% 30% 35% 3

24% 22% 20% 25%

What About 2012?

Equities outperformed all other Asset classes India 2nd Best performer in 2012.China the worst
30% 26%
35%

30% 25% 20%

29% 26% 23% 23%

25%
20% 15% 14% 17%

15% 15% 10%

14%

13% 11% 7%

10% 5%
0% 3%

8%

6% 3%

5% 0%

Equities (BSE 30)

Debt

Crude Oil

Gold

NHB Residex (India)

Sensex-Can it Catapult to 36,000?

Sensex EPS
2,800 2,500 2,200 1,900 1,600 1,300 1,000 700 400 100

CAGR = 15%

2014E

2015E

2016E

2017E

EPS

Current Market Value EPS P/E Multiple Average P/E multiple over last 15 years CAGR Assumed Sensex value Return CAGR return Div Yield Total Return

19000 1313 14 14 15% 36,959 94.52% 14.23% 1.50% 16%

2018E

1993

1994

1995

1996

2000

2001

2002

2003

2007

2008

2009

2010

1997

1998

1999

2004

2005

2006

2011

2012

2013

Equity-Ownership
FII- Hot money Main cause for volatility Retail Can become a force to reckon with
Indias household savings Breakdown
ADR/GDR, 3%
Retail, 8% DII, 11% Others, 8% BSE 500 ownership

$ Billion 329 161 27 168 20 57 10 9 47 24

% 100% 49% 8% 51% 6% 17% 3% 3% 14% 7%

Household Savings Physical Savings Gold Net Financial Savings Currency Deposits Shares & Debentures Claims on Govt Life Insurance Provident & pension Funds

Promoters
Promoters, 55% FII DII Retail ADR/GDR

FII, 15%

Others

35 30 29 24

25 20
15 10 5 0 -5 2006 2007 2008 2009 2010 8

18

17

-0.36 2011

2012

-10 -15
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Key Objectives
A. Understand the Valuation Framework
B. Understand Valuation process and methodologies in light of Industry best practices C. Understanding Valuation of Financial Services companies (Bank/NBFCs) from Indian stock market perspective D. Understanding Valuation of Defensive companies (FMCG/IT) from Indian stock market perspective E. Understand which Valuation methodologies work best with which Industries from Indian stock market perspective

What does Valuation mean

In an efficient market, firm value is defined as the present value of payoffs which the firm is expected to deliver to its shareholders in the future, discounted at the appropriate risk adjusted rate of return (Kothari, 2001, p. 108-109).
Valuation = Assumptions + Judgements World economy will grow at 3.7% in CY13 Assumption; Commodities (Copper , Aluminium, Coal, Oil) prices will trend up Judgement Inflation will soften to ~7% in India and hence RBI will be able to cut rates Assumption; Corporate profitability increases as debt burden goes down Judgement Eurozone will see gradually recovery in 2013 Assumption; Dollar index will weaken with EUR/$ breaching EUR 1.35 by Dec13- Judgement

The Valuation Process

Keeping in mind, industry best practices- Valuation a 4 step Process 1. Understanding the Business : Industry attractiveness and structure, Long term demand and supply scenarios, competition and strategies 2. Forecasting Company performance :Relevant Industry variables, company sales, margins, leverage and cash flows 3. Selecting the appropriate Valuation Model: Whether going concern or liquidation, intrinsic value or relative valuation, capital intensive or asset light, cyclical or defensive 4. Making Investment decision : Defined by returns generated

The Valuation Models

Industry basically differentiates between 3 types of Valuation methodologies

1. Intrinsic Value models: Assumes stocks value is a function of the net present value of its future payouts Dividend Discount model and Free Cash flow models 2. Relative Value models: Assume that a companys value is determined by comparing it to similar or peer companies, or perhaps even indices or benchmarks P/E, P/BV, P/CF, P/S, EV/EBITDA 3. Residual Value models: Assume that a companys value is a function of current Book value and present value of future residual income (ROE-COE)

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The Valuation Models

Industry basically differentiates between 3 types of Valuation methodologies

1. Intrinsic Value models: Assumes stocks value is a function of the net present value of its future payouts Dividend Discount model and Free Cash flow models 2. Relative Value models: Assume that a companys value is determined by comparing it to similar or peer companies, or perhaps even indices or benchmarks P/E, P/BV, P/CF, P/S, EV/EBITDA 3. Residual Value models: Assume that a companys value is a function of current Book value and present value of future residual income (ROE-COE)

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Market Valuation Methodologies

DDM DCF P/E P/BV EV/EBITDA P/S PEG RIV AEG Intrinsic FMCG/Banks/Auto FMCG/IT/Power/Telecom/Oil and Gas/Auto/Real estate/Steel Relative Residual

FMCG/IT/Auto Banks/NBFC/Utilities/Real Estate Power/Telecom/Utilities/Steel/Oil and gas/Power Start ups/Early stage/Insurance/Pharma IT/Banks Banks/NBFC/Insurance Banks/NBFC/Insurance

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DCF Framework and Firm Value

DCF model discounts projected free cash flows at WACC and adjusts for net debt to derive equity value
Projected income statement Projected balance sheet
DCF = valuation of firms or assets projected free cash flows in perpetuity using its risk-adjusted weighted average cost of capital (WACC)

10 years explicit and perpetuity 10 years explicit and perpetuity

T O D A Y

Projected free cash flows

Enterprise value
Weighted average cost of capital

Debt

Cash equity investments

Equity value

P R I C E S E S S E N T I A L

Weighted by current share of firm value

DC F

E X P L A I N S

S H A R E

Cost of equity

Cost of debt

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Free Cash Flow Defined..

Free cash flow calculation
Cash generation is defined as cash generated by operations and available to providers of capital (debt and

equity) after reinvestment in operations of the firm i.e. before interest and dividends but after tax
Cash generation = free cash flow Free cash flow definition

S H A R E

P R I C E S E S S E N T I A L

EBITDA Depreciation & amortisation = EBIT (excluding interest income/expense) Taxes = NOPAT + Depreciation & amortisation Capital expenditures Increase in net working investment Increase in other assets + Increase in other liabilities = Free cash flow
Perpetuity calculated by projecting steady-state free cash flows in year 11 (assuming 10 year explicit

T O D A Y

period)
NPV of year 11 free cash flow = FCFII

E X P L A I N S

where g = long-term real GDP growth

(WACCg)(1+WACC)10

DC F

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Valuation of IT Sector
A. IT companies in India witnessing High Growth era
B. Cash Rich companies with virtually zero debt C. Asset light No tangible assets Manpower key resource

D. DCF, P/E and PEG right valuation methodologies

E. ROIC and not ROE right return measure

Infosys_model IMT

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Valuation of FMCG Sector

A. FMCG companies in India witnessing Stable Growth era
B. High Dividend Yield companies with virtually zero debt D. DCF, P/E and DDM right valuation methodologies

E. ROE very high due to high asset turnover

F. FMCG companies run negative working capital cycles due to efficient management

HUL IMT DCF Methodology

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Valuation of Banking Sector

A. Banking companies in India witnessing High Growth era
B. Sector displays peculiar characteristics as Interest paid and received forms part of operating activities D. DCF not the right method to value Banking/NBFC E. Much talked about Residual income/Excess Value is the right technique F. Valuation is the most complex given many moving parts

Axis Bank Ltd IMT Model

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