A REPORT

ON

VALUATION METHODS
By

Arjun Vikas

2011A1PS430P

AT

A Practice School II Station of

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE, PILANI

(March, 2015)

A REPORT

ON

VALUATION METHODS
By
Name of the student(s)

Arjun Vikas

ID No(s)

2011A1PS430P

Discipline(s)

Chemical Engineering

Prepared in the partial fulfillment of the

Practice School II Course

AT

A Practice School II Station of

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE, PILANI

(March, 2015)

ACKNOWLEDGEMENTS
I am indebted to my manager and guide Mr. Gaurav Surana, Vice President and Head of
Mergers & Acquisitions Team for his valuable inputs and help provided during my work at
JP Morgan.
I would also like to extend my gratitude towards Mayank Kumar who has been cordial
enough to manage our internship and provide valuable inputs regarding our progress at JP
Morgan.
I would also like to thank my mentor Viral Shah for providing his deep insight about the
topic and explaining to me the entire concept of discounted cash flows.
I would also like to express my appreciation for Mr. Vijay Reddy, co-ordinator of the PS
program in Mumbai, and Mr. Krishnamurthy Bindumadhavan , my PS instructor, for all their
efforts in organizing the program, including the different evaluation components as well as
for making sure that it is convenient for us.

BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE

PILANI (RAJASTHAN)
Practice School Division

Station: JP Morgan Services

Centre: Mumbai
Date of Start: 12th Jan 2015

Duration: 5 Months
Date of Submission: 18th June 2015
Title of the Project: Valuation Methods
ID No./Name(s)/: 2011A1PS430P
Discipline(s) of the
Student(s)

Arjun Vikas

Chemical Engineering

Name(s) and: Gaurav Surana

Designation(s): Vice President
of the expert(s)
Name(s) of the:
PS Faculty

Krishnamurthy Bindumadhavan

Key Words: Discounted cash flow, Relative Valuation (Transaction & Trading
Comparables)
Project Areas: Financial Management
Abstract:
JP Morgan uses various financial models to assess the viability of a particular investment.
DCF or discounted cash flows is an important valuation model used at JP Morgan. DCF uses
future free cash flow projections and discounts them (most often using the weighted average
cost of capital) to arrive at a present value, which is then used to evaluate the present worth of
the company. Relative valuation is another frequently used tool for valuing companies. It
uses various ratios like P/E, EV/EBITDA to calculate the worth of the companies. This is
arrived at using the comps models developed at JP Morgan.

Signature(s) of Student(s)
Date

Signature of PS Faculty

Contents
Introduction ............................................................................................................................................................ 6
DCF Model ............................................................................................................................................................. 7
Time Value of Money ......................................................................................................................................... 7
WACC ............................................................................................................................................................ 7
Dividend Discount Model................................................................................................................................... 8
Free Cash Flows ................................................................................................................................................. 8
EBIT (1-T) or NOPAT(Net Operating Profit After Tax) ............................................................................... 9
Depreciation & Amortization ......................................................................................................................... 9
Change in Net Working Capital...................................................................................................................... 9
Capital Expenditure .......................................................................................................................................... 10
Initial Cash Flow .......................................................................................................................................... 10
Terminal Cash Flow ..................................................................................................................................... 10
Analysis ............................................................................................................................................................ 11
Benefits ................................................................................................................................................................. 11
Drawbacks ............................................................................................................................................................ 11
Topics Remaining ................................................................................................................................................. 12
Sources ................................................................................................................................................................. 13

INTRODUCTION
Discounted cash flow analysis is a method of valuing a project, company, or asset using the
concepts of the time value of money. All future cash flows are estimated and discounted by
using cost of capital to give their present values (PVs). The sum of all future cash flows, both
incoming and outgoing, is the net present value (NPV), which is taken as the value or price of
the cash flows in question. The cash flows are discounted based on the weighted average cost
of capital (WACC) which acts as the discount rate.

The formula for calculating DCF is given by:

PV = CF1 / (1+k) + CF2 / (1+k)2 + [TCF / (k - g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate/WACC
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
The DCF model is frequently used in both macro and micro scale, from outright purchase of
a new company to purchase of a machine. The cash flows which will be considered in the
report are the free cash flows which can be calculated as operating profit + depreciation +
amortization of goodwill - capital expenditures - cash taxes - change in working capital.
Relative Valuation is a business valuation method that compares a firm's value to that of its
competitors to determine the firm's financial worth. Relative valuation models are an
alternative to absolute value models, which try to determine a company's intrinsic worth
based on its estimated future free cash flows discounted to their present value. Relative
valuation is done by comparing ratios such as P/E, EV/EBITDA, EV/Sales, etc for the peers
of the company that one is trying to value. These multiples are arrived at using either trading
or transaction comps. The multiples used in trading or transaction comparable are same i.e.
EV/EBITDA, EV/SALES, P/E. Trading multiples are obtained for companies that trade on
the market, effectively public companies whereas transaction comps compare transactions
that happen(acquisitions) and the price buyer pays, to derive the multiples.

DCF MODEL
Time Value of Money
The idea that money available at the present time is worth more than the same amount in the
future due to its potential earning capacity. This core principle of finance holds that, provided
money can earn interest, any amount of money is worth more the sooner it is received.
In simple terms $100 today is worth more than $100 tomorrow because the money is always
depreciating. This is known as time value of money.
The present value (PV) formula has four variables, each of which can be solved for:

There is a certain rate at which the money is depreciated and that is known as discount rate or
weighted average cost of capital (WACC) in our case. Another variable that needs to
specified is the time period or the intervals at which money is expected to be received.

WACC
The weighted average cost of capital (WACC) is the rate that a company is expected to pay
on average to all its security holders to finance its assets. The WACC is commonly referred
to as the firms cost of capital. Importantly, it is not dictated by management. Rather, it
represents the minimum return that a company must earn on an existing asset base to satisfy
its creditors, owners, and other providers of capital, or they will invest elsewhere.
The rate for debt and equity differ as the risks on them are different. A general formula for
calculating WACC is:
WACC = ke (E / A) + kd (1 T) (D / A)
Where:
ke = rate of return on equity
kd = rate of return on debt
E = amount of equity raised
D = amount of debt raised
A = E+D
T= tax rate

Dividend Discount Model

Its the simplest model for valuing equity-- the value of a stock is the present value of
expected dividends on it. While many analysts have turned away from the dividend discount
model and viewed it as outmoded, much of the intuition that drives discounted cash flow
valuation is embedded in the model. In fact, there are specific companies where the dividend
discount model remains a useful took for estimating value.
The General Model
When an investor buys stock, he generally expects to get two types of cashflows- dividends
during the period she holds the stock 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 above formula is also called the Gordon Growth Model.

The rationale for the model lies in the present value rule - the value of any asset is the present
value of expected future cash flows discounted at a rate appropriate to the riskiness of the
cash flows.
There are two basic inputs to the model - expected dividends and the cost on equity. To
obtain the expected dividends, we make assumptions about expected future growth rates in
earnings and payout ratios. The required rate of return on a stock is determined by its
riskiness, measured differently in different models - the market beta in the CAPM, and the
factor betas in the arbitrage and multi-factor models. The model is flexible enough to allow
for time-varying discount rates, where the time variation is caused by expected changes in
interest rates or risk across time.
Limitations:
The Gordon growth model is a simple and convenient way of valuing stocks but it is
extremely sensitive to the inputs for the growth rate. Used incorrectly, it can yield misleading
or even absurd results, since, as the growth rate converges on the discount rate, the value goes
to infinity

Free Cash Flows

Free cash flows are a measure of financial performance calculated as operating cash flow
minus capital expenditures. It represents the cash that a company is able to generate after
laying out the money required to maintain or expand its asset base. Free cash flow is
important because it allows a company to pursue opportunities that enhance shareholder
value. Without cash, it's tough to develop new products, make acquisitions, pay dividends
and reduce debt.
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FCF can be divided into FCFE(Free Cash Flow to Equity) & FCFF(Free Cash Flow to Firm):
FCFE
This is a measure of how much cash can be paid to the equity shareholders of the company
after all expenses, reinvestment and debt repayment.
Calculated as: FCFE = Net Income - Net Capital Expenditure - Change in Net Working
Capital + New Debt - Debt Repayment
FCFF
A measure of financial performance that expresses the net amount of cash that is generated
for the firm, consisting of expenses, taxes and changes in net working capital and
investments.
Calculated as:

Explanation of the terms:

EBIT (1-T) or NOPAT(Net Operating Profit After Tax)
EBIT (1-T) is the income generated by the operating activities after deducting the tax from
the operating profit.
The sales from the new investment is calculated by various estimation methods and then its
operating costs are deducted like the cost of goods sold and selling, general and
administrative costs, We then arrive at the EBIT from which the tax is deducted to obtain the
first component of free cash flows.
Depreciation & Amortization
This is an important step in the DCF analysis. Depreciation & Amortization or D&A is the
reduction in the value of an asset over the period of time due to wear and tear or reduction in
goodwill in case of intangible assets. Depreciation is for tangible assets and amortization is
used for intangible assets. There are also various models for calculation of these components
which will not be discussed in this report.
D&A is subtracted from gross profit to arrive at EBIT and then again subtracted from the
after tax EBIT as these are not considered operating cash flows.
Change in Net Working Capital
Changes in Working Capital is the net change in current assets and current liabilities.
Working Capital is a measure of a company's short term liquidity or its ability to cover short
term liabilities. Working capital is defined as the difference between a company's current
assets and current liabilities.

Working Capital = Current assets Current liabilities

Capital Expenditure
Initial Cash Flow
Every investment requires an initial cash flow as it is required to purchase a product or a
company in a macro level. The amount of money spent on the investment initially is the
initial cash flow. In some cases there may be an exchange involved or selling of assets which
will produce a positive effect on the initial cash flow. This is a cash flow which is in present
and thus do not have to be discounted.
Terminal Cash Flow
Terminal cash flow is generally a positive cash flow unlike initial cash flow. It is the amount
of cash generated by selling of the investment or after the investment has run its due course.
It is the last cash flow in the DCF model is the one which has the maximum impact from the
discount rate.

10

Analysis
After obtaining all the cash flows and the discount rate we apply the discounting formula and
obtain the final net present value of the investment.
If NPV > 0 then the investment is profitable and should be undertaken
If NPV < 0 then the investment is not profitable and thus should be forfeited
Also in case of companies this model can be used to calculate their future cash flows and
subsequently their values.
Suppose ABC Company is having an interest in XYZ Company and wishes to acquire it.
In the DCF model the operating cash flows will be effected as the sales and operating costs
will be different and there will also be a huge initial cash flow because of the acquisition cost.
This will lead to a final table of cash flows which will be used to calculate the internal rate of
return and if the IRR > WACC then the acquisition should be done otherwise scrapped.

BENEFITS
Accounting scandals and inappropriate calculation of revenues and capital expenses give
DCF model of valuation new importance. With heightened concerns over the quality of
earnings and reliability of standard valuation metrics like P/E ratios, more investors and
analysts are turning to free cash flow, which offers a more transparent metric for estimating
performance than earnings.
Developing a DCF model demands a lot more work than simply dividing the share price by
earnings or sales. But in return for the effort, investors get a good picture of the key drivers of
share value: expected growth in operating earnings, capital efficiency, balance sheet capital
structure, cost of equity and debt, and expected duration of growth.

DRAWBACKS
Discounted cash flow models are powerful, but they do have shortcomings. Small changes in
inputs can result in large changes in the value of a company. Investors must constantly
second-guess valuations; the inputs that produce these valuations are always changing and are
susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While
forecasting cash flows more than a few years into the future is difficult, shaping results into
eternity (which is a necessary input) is near impossible. A single, unexpected event can
immediately make a DCF model obsolete. By guessing at what a decade of cash flow is
worth today, most analysts limit their outlook to 10 years
11

Topics Remaining
I will be covering Relative Valuation in detail in the remaining months. That will include
Trading & Transaction Comps in detail.
Overview of Relative Valuation:
Relative Valuation is a business valuation method that compares a firm's value to that of its
competitors to determine the firm's financial worth. Relative valuation models are an
alternative to absolute value models, which try to determine a company's intrinsic worth
based on its estimated future free cash flows discounted to their present value. Relative
valuation is done by comparing ratios such as P/E, EV/EBITDA, EV/Sales, etc for the peers
of the company that one is trying to value. These multiples are arrived at using either trading
or transaction comps. The multiples used in trading or transaction comparable are same i.e.
EV/EBITDA, EV/SALES, P/E.
Trading multiples are obtained for companies that trade on the market, effectively public
companies whereas transaction comps compare transactions that happen(acquisitions) and the
price buyer pays, to derive the multiples.

12

Sources
1. Investopedia
2. Wikipedia
3. Security Analysis and Portfolio Management (English) 1st Edition- S. Kevin
4. Damodaran on Valuation- A. Damodaran

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