NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-6
Session-11
Valuation of Equity Shares - I
Outline
Why Valuation?
Valuation of Firm vs. Equity
Measures of Valuation
Asset-based Valuation
Relative Valuation or Valuation based on Multiples
Why Valuation?
The decision to buy or sell a security is driven by the valuation of such security. Depending upon under
valuation or over valuation, the investor may take a buy or sell decision. Investors do look for securities
that are mispriced so that they can gain from the same. Valuation of security as done by a suitable method
is known as intrinsic value. There are several methods of valuation depending upon the type of security.
For securities like bonds, debentures and preference shares the method of valuation is bit simple because
of limited uncertainty about the future cash flows associated with such securities. However equity
valuation is not as simple as other securities. There are numerous ways an equity share can be valued.
Valuation is also fundamental to decisions by potential acquirers, lenders [when they lend against
securities], inviting investors as partners etc.
Valuation of Firm vs. Equity
For valuing an equity share there are two broad types of techniques, viz. Direct and Indirect. As per direct
approach, the equity shares are valued on their own. In case of indirect approach, the firm or the company
is valued as a whole and subsequently value of equity is derived out of that essentially after deducting the
claims of other financial stakeholders from the value of the firm. In case of firms where there is no other
financial stakeholder except equity holders, the value of firm and value of equity are one and same.
Classic Measures of Value:
The valuation measures can be classified as below:

Asset based Measures

Valuation Multiples or Relative Valuation Measures
Discounted Cash Flow based Measures
Venture Capital/ Private Equity Approach
Valuation in case of Mergers and Acquisitions

Asset based Valuation Measures: Balance sheet of a company as on a particular date reflects the assets
and liabilities. The claims of all the stakeholders are reflected in the assets of the company. The total of
the assets owned by the company can be considered as the value of the company. In case of asset based
valuation methods, the fictitious assets [like debit balance of Profit & Loss Account, Miscellaneous
Expenditure not written-off, etc.] and goodwill are not considered for valuation. Those are considered
zero for the purpose of calculation. The different asset based valuation measures are discussed below.
Book Value: The term book means the accounting books. When one considers the value of assets as
reflected in the balance sheet such value is known as book value. In total of assets except the fictitious
assets is known as the value of the company or firm. Total book value of assets less book value of
outsiders liabilities is taken as book value of equity.Book value of equity divided by number of equity
shares gives book value per share. Since the balance sheet presents the audited figures, the value derived
by this approach can be considered as authentic, unless one has doubt about the financial reporting
system.
Adjusted Book Value: One of the limitations of book value method is that the assets are recorded at
historical cost and do not reflect the realizable value. Hence, as per adjusted book value method, the book
value of assets are adjusted according to market value of assets then. Similarly the outsiders liabilities are
also adjusted if necessary. Table 1 shows the valuation of equity share of a hypothetical company as per
book value and adjusted book value method.
Table 1: Book Value and Adjusted Book Value of Equity
Book
Value

Market
Value

Net Fixed Assets

200

220

Investments

100

110

Inventory

30

32

Receivables

50

48

Cash and bank

40

40

--

200

200

10

10

Value of Eligible Assets [Value of Company]

420

450

Value of Assets less value of liabilities

220

250

Rs.22

Rs.25

Particulars (figures are in Rs. Million)

Miscellaneous Expenses to the extent not written off

Outsiders liabilities
Number of equity shares (in million)

Value per share

Asset-based valuation measures are suitable for such companies whose value is driven by the assets held
by the companies. These measures do not consider other sources of value creation like brand, image,
human resources etc. These are intangible assets and affect the revenue generation process of companies
in almost all the sectors.
Valuation Multiples orRelative Valuation: The relative valuation concept or comparable company
approach suggests that a firm or company can be valued by comparing it to similar firms on the basis of
2

several relative ratios. Relative ratios compare the firms value (or equity value) to some aspect of the
firms economic activity, such as cash flow, sales or EBITDA (earnings before interest, tax, depreciation
and amortization), profit after tax, etc. Multiples are appropriate and easy to use when the comparison is
made between two assets that are similar in nature. Multiples also vary over time. Market multiples that
are generally drawn from stock prices for public companies are known as trading multiple and those
drawn from completed transactions (e.g. a merger or acquisition) are known as transaction multiple.
While selecting the comparable companies for a particular company [say target], one has to make a
thorough analysis of its product space, product market performance, drivers of performance, suppliers,
customers and competitors. This list is not exhaustive. It is also necessary to adjust the financial
parameters to make those comparable to the comparable companies. Afterwards the average of the
relative valuation measure for comparable companies is found out and applied to value the target
company or its equity as the case may be. For the purpose of average, median is appropriate.
Examples of Valuation Multiples for Equity: Valuation multiples of comparable companies can be found
out by comparing the entire value of the equity with the absolute value of the performance parameter, say
profit after tax, dividends or cash flow. This can also be done on per share basis.
Table 2: Select Valuation Multiples for Equity Valuation
Valuation Multiple or Ratio

Aggregate basis Measure

Price Earning Multiple

Market Capitalization / (Profit Market price per share (MPS) /

after
tax
less
preference Earnings per Share (EPS)
dividends)

Price to Dividend Multiple

Market Capitalization / Equity MPS / Dividend per share

Dividend

Price to Book Value Multiple

Market
Worth

Price to Cash Flow Multiple

Market Capitalization / Cash MPS / CF per share

flow

Capitalization

Per share basis Measure

Net MPS / Book Value per shrae

Table 3: Valuation of a Sample Pharmaceutical Company

Company Name

P/E*

P/B*

Cipla Ltd.

21.99

3.93

Divi'S Laboratories Ltd.

14.66

4.89

Dr. Reddy'S Laboratories Ltd.

14.68

1.57

Glaxosmithkline Pharmaceuticals Ltd.

20.14

5.47

Glenmark Pharmaceuticals Ltd.

18.11

3.21

Lupin Ltd.

13.69

4.15

Piramal Healthcare Ltd.

14.75

3.41

Sterling Biotech Ltd.

21.43

1.89

Sun Pharmaceutical Inds. Ltd.

18.21

4.47
3

Median
Target Company EPS and Book Value per share
respectively (Rs.)
Value per share (as per P/E and P/B multiple respectively)

18.11

3.93

Rs. 5.00

Rs. 25

Rs.5.00x18.11
= Rs.90.55

Rs.25.00x3.93
=Rs.98.25

* As found out in 2099-10

Examples of Valuation Multiples for the Firm [or Enterprise]: In this case the value of the entire firm or
enterprise is derived by applying suitable multiples. Enterprise value is the sum of value of equity,
preference share and interest bearing debt.
Valuation Multiple or Ratio

Measure

EBIT Multiple

Enterprise Value / Earnings before Interest and Tax

EBITDA Multiple

Enterprise Value / Earnings before Interest, Tax, Depreciation and

Amortization

Sales Multiple

Enterprise Value / Sales

Total Assets Multiple

Enterprise Value / Total Assets

Enterprise Value/EBITDA Multiple: This multiple is widely accepted as tool for valuation in case of
mergers and acquisitions. EBIDTA neutralizes the effect of differences in financial leverage [affecting
interest], depreciation policy and tax policy of the firms that are considered. That is why the firms become
comparable. EBIDTA also reflects the core earnings of the firm. It also takes care of firms with negative
earnings.
There are two ways this multiple can be presented (Damodaran (2007)).
The Classic Definition
Value
Market Value of Equity + Market Value of Debt

EBITDA
Earnings before Interest, Taxes and Depreciati on

The No-Cash Version: When cash and marketable securities are netted out of value, none of the
income from the cash and securities should be reflected in the denominator.

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

EBITDA
Earnings before Interest, Taxes and Depreciation

Relative valuation techniques are certainly suitable for unlisted companies or companies the shares of
which are thinly traded in the market. The relative valuation need not be limited to financial parameters. It
can also be based on key operating parameters or characteristics of the firms in a particular sector, like,
number of subscribers for an internet service provider, number of patents, number of employees,
megawatt hour capacity etc. One of the limitations in relative valuation is the subjectivity involved. In the
next session, the cash flow based valuation is discussed.

References:
Damodaran, Aswath (2007), Corporate Finance Theory and Practice, 2e, Wiley India
Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage)
Learning, New Delhi
Bodieet al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New
Delhi

Questions and Answers

Q.1: List different methods or techniques of valuing equity share.
Ans.: The different methods of valuing an equity share are as below:

Asset based Measures

Book value of Assets less book value of liabilities (based on values as presented
in the latest balance sheet of the company)
Adjusted book value (valuation of assets and liabilities done on the basis of
market value)
Liquidation value (with the assumption that the firm will be liquidated, hence the
valuation is done more on piece meal basis)
Valuation Multiples or Relative Valuation Measures
Price/ Earnings Multiple
Price/ Book value Multiple
Price/ Cash flow Multiple
Price/ Sales Multiple
Discounted Cash Flow based Measures
Dividend discount model
Free cash flow to equity model
Valuation in case of Mergers and Acquisitions: based on similar types of companies that
went through merger/ acquisition.

Q.2.With the help of the following balance sheet of MNOP Limited find the value of equity
share as per book value and adjusted book value basis as on 31 March 2010. Figures are in Rs.
Crore.
SOURCES OF FUNDS

2009-10

2008-09

APPLICATION OF FUNDS

2009-10

2008-09

Gross Block

1,936.02

1,928.02

1209.66

1121.96

726.36

806.06

1,615.43

1,143.87

27.10

62.21

Inventories

103.55

89.69

240.33

Sundry Debtors

137.26

179.06

77.12

68.5

Cash and Bank

350.18

308.83

Share Capital (Face Value:

Rs.10)
Reserves Total

151.25

151.25

1,094.82

1,032.13

Less: Accumulated Depreciation

Total Shareholders Funds

1,246.07

1,183.38

Net Block

Secured Loans

1,044.07

790.2

Capital Work in Progress

20.00

50.00

Investments

1,064.07

840.2

Current Assets, Loans & Advances

Unsecured Loans
Total Debt
Less: Current Liabilities and
Provisions
Current Liabilities
Provisions
Total Current Liabilities

273.06

2,660.32

2,332.41

1.56

3.43

Loans and Advances

49.06

48.09

Total Current Assets

291.43

320.27

2,660.32

2,332.41

Ans. Book value of equity as on 31st March 2010 (in Rs. Crore) =
Total Assets Total Debt Total Current Liabilities = 2,660.32 1,064.07 350.18 = 1236.07
Number of equity shares = 15.125 crore
Value per share = Rs.1236.07 Crore / 15.125 crore = Rs.81.72
Q.3: Refer the question # 2 above. If the comparable companies average Market to Book Value
of equity is 1.3, what is the expected market value per share of MNOP?
Ans.: Expected value per share = Book value per share x M/B ratio = Rs.81.72 * 1.3 = Rs.106.24
Q.4: The shares of Ship limited trades at Rs.85. The average P/E multiple and Price/ Sales per
share multiple of companies in the same sector are 14 and 1.3 respectively. With the help of the
following information suggest if the shares of Ship Limited are under or over valued.

Particulars
Sales
Operating Expenses
Profit before interest and
tax (PBIT)
Interest
Profit before tax
Tax @ 40%
Profit after tax
Equity Share Capital
Reserves and Surplus

Amount
(Rs. Crore)
670
520
150
20
130
52
78
120
350

Ans.: Sales per share = Rs.670 crore / 12 crore = Rs.55.83

Price / Sales per share = 85/55.83 = 1.52 times (>1.3)
Earnings per share = Rs.78 crore / 12 crore = Rs.6.50
P/E ratio = 85/6.50 = 13.08 times (<14)
As per price/sales per share criteria, the share is overvalued whereas according to P/E multiple,
the share is undervalued.