Contact Hour 17

Valuation
07/10/2017
FIN ZG519: Business Analysis and Valuation
BITS Pilani Instructor: Prof. Mahalakshmi Mudliar
Methods of Valuation

Intrinsic valuation: The value of an asset is a function of its fundamentals-

cash flows, growth and risk. In general, discounted cash flow models are
used to estimate intrinsic value.
Relative valuation: The value of an asset is estimated based upon what
investors are paying for similar assets. In general, this takes the form of value
or price multiples and comparing firms within the same business.
Contingent claim valuation: When the cash flows on an asset are contingent
on external event, the value can be estimated using option pricing models.

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Valuation of Equity

The value of equity is obtained by discounting expected cash flows to equity,

i.e. the residual cash flows after meeting all expenses, tax obligations and
interest and principal payments, at the cost of equity i.e. rate of return
required by equity investors in the firm.

The dividend discount model is a specialized case of equity valuation and the
value of a stock is the present value of expected future dividends.

@Damodaran on valuation
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Firm Valuation

The value of the firm is obtained by discounting expected cash flows to the
firm, i.e. the residual cash flows after meeting all operating expenses and
taxes, but prior to debt payments, at weighted average cost of capital, which
is the cost of different components of financing used by the firm, weighted by
their market value proportions:

@Damodaran on valuation
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Choosing a Cash Flow to Discount

When you cannot estimate the free cash flows to equity or the firm, the only
cash flow that you can discount is dividends. For financial service firms, it is
difficult to estimate free cash flows.
If a firms debt ratio is not expected to change over time, the free cash flows
to equity can be discounted to yield the value to equity.
If a firms debt ratio might change over time, free cash flows to equity
become cumbersome to estimate. Here, we would discount free cash flows
to the firm.

@Damodaran on valuation
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Ingredients that determine value

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Tata Motors

Is a manufacturing firm with big chunks of its revenues coming from India and
China (about 24% each) and rest spread across developed markets.
The existing debt at Tata Motors is a mix of Indian Rupee debt (~ 71%) and
Euro debt (~ 29%) with an average maturity of 5.33 years and it is almost
entirely fixed rate debt.
As the firms debt ratio is not expected to change over time, the free cash
flows to equity can be discounted to yield the value of equity. For Tata
Motors, we will discount free cash flows to equity.

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Estimating Cash Flows

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Estimating FCFE for Tata Motors

Equity
Net Change Change Equity Reinvestment
Year Income CapEX Depr in WC in debt Reinvestment Rate
2008-09 -25053 99708 25072 13441 25789 62288 -248.62%
2009-10 29151 84754 39602 -26009 5605 13538 46.44%
2010-11 92736 81240 46510 50484 24951 60263 64.98%
2011-12 135165 138756 56209 22801 30846 74502 55.12%
2012-13 98926 187570 75648 680 32970 79632 80.50%
Aggregate 330925 592028 243041 61397 120161 290223 87.70%

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Discount Rates

Critical ingredient in discounted cash flow valuation. Errors in estimating the

discount rate or mismatching cash flows and discount rates can lead to
serious errors in valuation.
At an intuitive level, the discount rate used should be consistent with both the
riskiness and the type of cash flow being discounted.
The cost of equity is the rate at which we discount cash flows to equity
(dividends or free cash flows to equity). The cost of capital is the rate at
which we discount free cash flows to the firm.

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Regression Diagnostics for Tata Motors

Beta = 1.83
67% range 1.67-1.99

69% market risk

31% firm specific

Jensens
= 2.28% -4%/12(1-1.83)= 2.56% Expected Return (in Rupees)
= 1 + 0.0256 12 1 = 35.422% = Risk free Rate +Beta * Risk premium
Average monthly riskfree rate (2008-13)=4% = 6.57% +1.83 (7.19%)= 19.73$

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Cost of Equity: Tata Motors

Estimated unlevered beta for 76 publicly traded automotive companies

(globally) is 0.8601
Estimated levered beta based on Tata Motors D/E ratio of 41.41% and
marginal tax rate of 32.45% for India:
Levered Beta for Tata Motors = 0.8601(1+(1-0.3245)(0.4141))=1.1007
Since we will be discounting FCFE with income from cash included in the
cash, we recomputed a beta for Tata Motors as a company (with cash):
Levered Beta (Company)=1.1007(1428/1630)+0(202/1630)=0.964
With a nominal rupee risk-free rate of 6.57% and an equity risk premium of
7.19% for Tata Motors, we arrive at a cost of equity of 13.50%
Cost of Equity = 6.57% + 0.964(7.19%) = 13.50%

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Expected Growth

Expected Growth

Operating
Net Income
Income

Reinvestment
Retention Ratio Return on Equity Return on Capital
Rate = Net CapEx
(1-Dividends/ Net Income/Book = EBIT (1-t)/ Book
+ Chg in WC /
Net Income) Value of Equity Value of Capital
EBIT (1-t)
@Damodaran on valuation
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Estimating growth in Net Income: Tata
Motors
Equity
Net Change in Change in Equity Reinvestment
Year Income CapEX Depr WC debt Reinvestment Rate
2008-09 -25053 99708 25072 13441 25789 62288 -248.62%
2009-10 29151 84754 39602 -26009 5605 13538 46.44%
2010-11 92736 81240 46510 50484 24951 60263 64.98%
2011-12 135165 138756 56209 22801 30846 74502 55.12%
2012-13 98926 187570 75648 680 32970 79632 80.50%
Aggregate 330925 592028 243041 61397 120161 290223 87.70%

BV of Equity
Net at start of the
Year Income year ROE Average
Values: 2008-
2008-09 -25053 91658 -27.33%
2013 value 2013
2009-10 29151 63437 45.95%
Reinvestment Rate 80.50% 87.70%
2010-11 92736 84200 110.14% ROE 29.97% 43.34%
2011-12 135165 194181 69.61% Expected growth 24.13% 38.01%
2012-13 98926 330056 29.97%
Aggregate 330925 763532 43.34%

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Closing the Valuation

Since we cannot estimate the cash flows forever, we estimate cash flows for
a growth period and then estimate a terminal value, to capture the value at
the end of the period:
=

=
+
(1 + ) (1 + )5
=1
When a firms cash flows grow at a constant rate forever, the present value
of those cash flows can be written as:
Value = Expected cash flow for Next Period / (r-g)
Where, r= Discount rate (Cost of Equity or Cost of Capital)
g= Expected growth rate forever
This constant growth rate is called a stable growth rate and cannot be
higher than the growth rate of the economy in which the firm operates.

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Getting to stable growth

A key assumption in all discounted cash flow models is the period of high
growth, and the pattern of growth during that period. In general, we can make
one of three assumptions:
There is no high growth, in which case the firm is already in stable growth
There will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-
stage)
There will be high growth for a period, at the end of which the growth rate will decline gradually to a stable
growth rate (3 stage)

The assumption of how long high growth will continue will depend upon
several factors including:
The size of the firm (larger firm > shorter high growth periods)
Current growth rate (if high > longer high growth period)
Barriers to entry and differential advantages (if high > longer growth period)

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In case of Tata Motors:

Firm size / market Firm has a large market share of Indian (domestic)
size market but it is small by global standards. Growth is
coming from Jaguar division in emerging markets.

Current excess Firm has a return on capital that is higher than the
returns cost of capital
Competitive Has wide distribution service network in India but
advantages competitive advantages are fading. However,
Landrover / Jaguar has a strong brand name value,
giving Tata pricing power and growth potential.
Length of high- Five years, with much of the growth coming from
growth period outside India.

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Valuing Tata Motors with FCFE model

We use the expected growth rate of 24.13%, estimated based upon 2013
values for ROE (29.97%) and equity reinvestment rate (80.5%):
Expected growth rate = 29.97% * 80.5% = 24.13%
The cost of equity for Tata Motors is 13.50%:
Cost of equity = 6.57% + 0,964 (7.19%) = 13.50%
The expected FCFE for the high growth period
Current 1 2 3 4 5
Expected growth rate 24.13% 24.13% 24.13% 24.13% 24.13%
Net Income 98926 122794 152420 189194 234840 291500
Equity Reinvestment Rate 80.50% 80.50% 80.50% 80.50% 80.50% 80.50%
Equity Reinvestment 79632 98845 122693 152295 189040 234649
FCFE 19294 23948 29726 36898 45801 56851
PV of FCFE @13.50% 21100 23076 25236 27599 30183
Sum of PV for FCFE= 127,187 mill

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Valuation of Tata Motors

After five years, we assume that the beta will increase to 1 and that the equity risk
premium will decline to 6.98% (as the company becomes more global). The resulting
cost of equity is 13.55%
Cost of Equity in Stable Growth = 6.57% + 1*6.98%= 13.55%
Further, we assume that the growth in net income will drop to 6% and that the return on
equity will drop to 13.55% (which is also the cost of equity).
Equity Reinvestment Rate (at Stable Growth)= 6%/13.55% = 44.28%
FCFE in Year 6= 291,500 (1.06)(1-0.4428) = 136,822 mill
Terminal Value of Equity = 136,822/ (0.1355-0.06) = 2,280.372 mill

Value of Equity= PV of FCFE during high growth period + PV of terminal Value

=127,187 + 2,280,372/1.1355^5= 1,335,210
Dividing by 2694.08 million shares gives the value of equity per share of Rs. 495.61

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 BITS Pilani

Thank you