Firm Valuation

Abhinav Rajverma
 Firm Valuation
Why valuation?
A valuation is an objective search for “true” value
A good valuation provides a precise estimate of value
The more quantitative a model, the better the valuation

Discounted Cashflow Valuation (DCF): Present value of

expected future CFs
Relative Valuation: Estimates value by comparing with
‘comparable' firms (w.r.t. earnings, CFs, book value or sales)
Contingent Claim Valuation: Option pricing models to
measure the value of assets

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 DCF Valuation
In DCF Valuation, The value of an asset is the present value of
the expected cash flows on the asset.

Philosophical Basis: Every asset has an intrinsic value that can

be estimated, based upon its characteristics in terms of cash
flows, growth and risk

Information Needed: For DCF valuation, we need

To estimate the life of the asset
To estimate the cash flows during the life of the asset
to estimate the discount rate to get present value of CFs

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 Advantages & disadvantages
Advantages
Based upon firm’s fundamentals - less exposed to
market perceptions.
Helps to understand the underlying characteristics of the
firm, and its business.
For investors buying businesses, rather than stocks, it
helps to understand what will be received
Disadvantages
Requires far more inputs and information (difficult to
estimate) than other valuation approaches
Inputs and information can be manipulated by analysts
to have the conclusion he or she wants

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When DCF Valuation works best
DCF valuation approach is appropriate:
Current CFs are positive
Future CFs can be estimated with some reliability
A proxy for risk is available to be used to obtain
discount rates
Works best for investors
Having long time horizon: allowing market to
correct valuation mistakes and revert to “true” value
Capable of providing the catalyst needed to move
price to “true” value – if undervalued, may be a case
of potential acquisition

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 DCF Valuation: Formula
∞
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = ෍ 𝐹𝐶𝐹𝐹𝑡 Τ(1 + 𝑊𝐴𝐶𝐶)𝑡
𝑡=1

𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = σ𝑇𝑡=1 𝐹𝐶𝐹𝐹𝑡 Τ(1 + 𝑊𝐴𝐶𝐶)𝑡 + TV/(1 + 𝑊𝐴𝐶𝐶)𝑇

where,
FCFF = Free cash flow to firm
WACC = Weighted average cost of capital
TV = Terminal Value

* FCFF is the cash flow available to all funding providers.

FCFF = Net Income + Non-cash expenses + Interest (1-T) – Capex – ΔWC
FCFF = EBIT * (1-T) + Depr. – Capex – ΔWC
ΔWC = Increase in average (Inventory + Receivable – Payables)

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 Terminal Value
Stable Growth Model
𝑇𝑉 = σ∞
𝑡=𝑇+1 𝐹𝐶𝐹𝐹𝑡 = 𝐹𝐶𝐹𝐹𝑇 ∗ (1 + 𝑔)Τ 𝑊𝐴𝐶𝐶 − 𝑔
The stable growth rate (g) may be assumed to be equivalent or less than the
growth rate of the economy
Multiple Approach
P times of Financial Matrix (i.e. EBITDA)
Liquidation Value
Useful when assets are separable and marketable

Equity Value = Enterprise Value (EV) + Cash - Debt

Intrinsic Value (per share) = Equity Value/ No. of Shares

Compare Intrinsic Value with market value of share

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DCF Valuation: Formula
𝑊𝐴𝐶𝐶 = 𝐾𝑒 ∗ 𝑊𝑡𝑒 + 𝐾𝑑 ∗ 𝑊𝑡𝑑 ∗ (1 − 𝑇)

Cost of equity estimation:

 Dividend-growth model (r = D/P + g)
 Risk and return model (CAPM)
 Industry average model (Historical Industry Returns).

Cost of debt estimation:

 Interest expense/Total Debt

Assumptions:
 Dividend growth rate (g) => Should be less than GDP growth rate
 Corporate Tax rate = 30%

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 Example
Year CFs to Equity Interest (1-Tax) CFs to Firm

1 2,000 500 2,500

2 2,500 500 3,000

3 3,000 500 3,500

4 3,400 500 3,900

5 3,700 500 4,200

TV 97,125 110,250

CoE = 15%; CoD = 10%; Growth rate = 5%; Tax Rate = 30%;
D-E ratio = 3; Debt = Rs. 7,000; Shares (no.) = 1,000, Cash = Rs. 200
WACC = 0.15* 0.25 + 0.10 * 0.75 * (1 – 30%) = 0.09
Firm Value = 2,500/1.09+3,000/1.09^2+ …+ 4,200/1.09^5+TV/1.09^5
 13,014+71,655 = 84,669
 Value of Equity (Theoretical M.caps) = 84,669 + 200 – 7,000 = 77,869
Intrinsic Value/share = 77,869/1,000 (shares) = 77.87/share
Current Share Price = 50/share; Recommendation: Buy (undervalued)
 Assignment-3 (Group size-3)
Select a listed firm from existing three with net income and net worth (averaged over
last three years) positive. Using averaged data, project Income statement and Balance
sheet for next 5 years assuming business growth of 10% (Y-o-Y). Suitably assume
new capital expenditure and depreciation. Also assume 10% increase Y-o-Y in
average inventories, receivables, and payables for change in working capital. For
firms paying no-dividend, assume CoE of 15%
1. Calculate Cost of equity and cost of debt
2. Find leverage ratio for each year
3. Calculate WACC for each year
4. Calculate Firm value assuming firm attends terminal growth rate of 4% from
sixth year.
5. Calculate intrinsic value of stock and compare it with current share price
*Supply step-wise calculation for each questions (1-5). P&L statement and Balance
sheet to be supplied in standard format with data in lakhs/millions (rounded to 3
decimal points). Supply printouts of only relevant data. Supplying printouts of
redundant data will attract penalty.
Submission due: May 6, 2019 (5:30 PM)

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 Income Statement
P&L account Base Year Y1 Y2 Y3 Y4 Y5
(Rs. Lakhs)
Net Revenue (a)
Total Expense (b)
EBITDA (c=a-b)
Depreciation And Amortization (d)
EBIT (e=c-d)
Interest Expense (f)
PBT (g=e-f)
Less: Corporate Tax
PAT
Add: ExtraOrdinary Items
Add: Income (after tax) from
discontinuing operations
Net Income
Less: Dividends paid (Including DDT)
Transfer to Reserves & Surplus

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 Balance Sheet
Balance Sheet Base Year Y1 Y2 Y3 Y4 Y5
(Rs. Lakhs)
EQUITIES AND LIABILITIES
Share Capital
Reserves and Surplus
Shareholder Fund
Non-Current Liabilities
Short-term Borrowings
Trade Payables
Other Current Liabilities & Provisions
Current Liabilities
TOTAL LIABILITIES XYZ
ASSETS
Non-current Assets
Cash & Cash Equivalents
Inventories
Trade Receivables
Other Current assets
Total Current Assets
Total Assets XYZ
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