Introducti

on
 CHAPTER I
INTRODUCTION

1.1 Introduction

“Price is what you pay, value is what you get” said Warren Buffet one of the world’s
greatest investors. Intrinsic value is the strength of a stock and greater this value, the
more it is a safe bet from the point of view of investment.

The vision for the stakeholder is that a business should be measured by its true
value and use true costs and true profits in its internal and external reporting. Profit
and loss, Performance and Value creation should be redefined and stock prices
should reflect the true value, profits and costs of the company.

Valuation is a method of estimating the economic value of an asset or

capital. The valuation of business encompasses a set of procedures used to
estimate the economic value of an owner’s interest in the business. The premise of
valuation is that a reasonable estimate of value for most of the assets can be
made and that the fundamental principles that determine the value of all types of
assets remain the same.

Valuation also provides a road map for increasing a firm’s future growth,
helping to recognise what adds to its worth by improving future business decisions.
Managers who focus on shareholder value will create healthier companies than those
who do not. Healthier companies will in turn lead to higher economies, more career
and business opportunities for individuals and higher standards of living.

Today, India is the biggest among the emerging market economies. The Indian
stock market holds a place of prominence with bourses such as Bombay Stock
Exchange (BSE) and National Stock Exchange (NSE). The BSE is one of the world’s
oldest stock exchanges with a total number of companies double that of the London
Stock Exchange, NASDAQ and NYSE companies quoted in its market today. The
National Stock Exchange is the best in terms of sophistication and advancement of
technology. Several studies have proved the inefficiency existing in the stock markets.
Though the stock markets are rapidly moving towards efficiency and there is a lower
possibility of making abnormal gains in the process, still inefficiency persists. The

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implication of inefficiency is that companies with low true values may be able to
mobilise a lot of capital while

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companies with high true values may find it difficult to raise capital. This disrupts the
investment scenario in our country and also has an impact on productivity. The major
problem for the economy is that the investment funds are not appropriately channelized
to where they are mostly useful. This resource misallocation in the long run is
destructive as it would hinder the sustainable development of the economy. In this
regard, the current study highlights the need for a proper allocation of resources as the
stock prices should match the intrinsic value of the stock. In other words, the investors
should pay the prices which reflect the true worth of the stock thereby channelizing
funds to where it can be most effectively used.

Economic reforms after 1991 opened the gates to foreign competition in India.
Multinational Companies (MNCs) through inflows and Foreign Direct Investment
provided most of the technological inventions, development and growth.In 2014, India
was the tenth largest GDP economy which stood tenth in terms of factory output and
fifteenth in service output. The McKinsey Global Institute reported in 2010 that there
were nearly 8,000 companies having annual revenues of more than one billion dollars
and three-fourths of these are based in developed countries. This scenario would
undergo a transformation over the next 15 years. By 2025, these multinational
Companies would double to 15,000 and seven out of ten of these would have their
corporate headquarters located in emerging countries like India, China and South
Korea. In this backdrop, it becomes imperative to focus on how these foreign entrants
create value as against their domestic counterparts in our country.

A new unfolding pattern has radically reshaped the global business landscape.
With the divergence of economies, global growth is poised to accelerate. Securities
and Exchange Board of India (SEBI) has relaxed the norms for MNCs in India.
Two decades ago the Foreign Direct Investment (FDI) norms had an upper cap
on the maximum ownership by a foreign entity, these foreign entities could not have a
hundred percent subsidiary of their business entity in India. This requirement led many
foreign companies to list their subsidiary in India.

In the present era of globalisation, privatisation and liberalisation

enormous growth opportunities are available for the corporate sector in India. But
the last few years has seen a change in the FDI policy in many sectors with
restrictions on

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ownership only in certain critical sectors. So the directive that made listing compulsory
was no longer applicable. Many MNCs like Philips, Panasonic, Ray Ban, Otis
and Carrier which were once listed on Indian bourses had been delisted. MNCs had
enough support from parent company and did not require financing from the Indian
capital market. This deprives Indian investors of investment in these profitable
companies and getting benefits there from.

The problem arises when stock markets are bearish; and when all the stock
prices fall. The suppressed market conditions leads to pessimism among the investors
who want to get out of equities. Most of the investors in this pessimistic environment
do not differentiate between good and bad investments. Promoters of MNCs usethis
kind of undervaluation to their advantage and acquire the remaining shares at a lower
valuation and applied for delisting. In the long run, the minority interest is affected as
they stand to lose the possible gains that could be made from MNCs. In the last few
years several MNCs like Hindustan Unilever Limited and GlaxoSmithKline Consumer
Healthcare Limited had made open offers to minority stakeholders to raise their stakes
in Indian subsidiaries. The Indian rupee is still favourable to open offers. The Business
Standard reported that in the first half of 2013, the open offers went up to a six year
high, worth Rs. 37,460 crores as compared to Rs. 1,721 crores in the previous year.
Moreover it is also necessary in the present era of globalisation to evaluate whether
these global giants have larger value creations than the traditional companies in India.
Hence, valuation methods enable the investors to stay invested considering their
stock’s intrinsic value and make gains in the long run.

1.2 VALUATION AND ITS ROLE IN MANAGERIAL DECISIONS

In an efficient market, the market price is the best estimate of value. But when
inefficiency prevailed in the market, it was assumed to make some mistakes in
assessing value and these mistakes can occur over entire sectors and sometimes even
the entire market. Assets were incorrectly priced over time and are assumed to get
corrected automatically with the receipt of new information. Valuation acts as a
catalyst needed to move price to value as needed for an active investor who makes
logical decisions of investment with long term horizon. Hence, using valuation would
allow the market to correct its valuation mistakes and for price to revert to its true
value.
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 Value creation is the ultimate measure of performance. It is essential to know
to what extent a business in its current performance creates value. For analysing a
firm, it is imperative to know the type of assets it owns, the value of these assets and
the degree of uncertainty about this value. Though the accounting statements did a
reasonably good job of categorising the assets owned by a firm and assessment of the
value of these assets, they largely fail to report the uncertainty about the asset value.
The accounting view of value of an asset is to a large extent grounded in the notion of
historical cost, where loss in the value of an asset is associated with the ageing
of the asset. In comparison, a valuation technique is able to make reasonable
estimates of value by quantifying future benefits with reasonable precision, as it treat
s an asset as a resource that has the potential to generate future cash inflows or to
reduce future cash outflows. Traditional financial analysis uses tools like return on
investment, return on equity and earnings per share based on Income Statement and
Balance Sheet. These analyses are based on arbitrary assumptions which fail to
consider cost of capital and timing of returns. But the current valuation techniques
were inbuilt with factors as cost of capital, risk, present value of future returns, growth
and reinvestment needs of the firm.

There are a range of reasons that business owners require for valuation like:

 commencing a sale process

 deciding the target price in a takeover or merger and acquisition

 resolving shareholder disputes

 determining tax obligations

 solving litigations

 accessingexternal sources of funding

 planning and future decision making.

Valuation is also of immense utility for Equity Research Analysts whose job
is to follow the movement of stock in sectors and make recommendations on the most
undervalued and overvalued stocks in a sector. Its use to Equity Portfolio Managers is
substantial as they had to be fully invested or stay close to fully invested. The
purpose of any valuation method is then to provide the true and fair value of the asset.

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 Valuation acts as a benchmark for comparison to the owners to see how well
the business is operating as compared to other similar businesses in the same industry.
Valuation also serves to raise expansion capital through lending institutions and
venture capitalists. It helps in valuing company’s stock for the development of
Employee Stock Option Scheme (ESOP) or bonus stock. Buyback of shares could
happen only with the use of valuation. Also valuation helps to determine the
price of an Initial Public Offering (IPO).

The valuation of firms is fundamental for identifying and stratifying the main
factors affecting value. Valuation helps in identifying and strengthening
businesses which are sustainable. It enables the management to make investment and
strategic decisions effectively. Further, more sustainable companies are recognised and
rewarded leading to a faster growth of the economy.

Inefficiencies in the market could even reward or punish managers on the

performance of the stock. Thus, a firm whose stock price has gone up is viewed as
creating value, and if the stock price has declined it has destroyed value. Hence,
compensation systems based on the stock prices would also go wrong. Thus, a firm may
see its stock prices go up and its top management rewarded, even as it has destroyed
value. Today, the compensation systems based on stock prices like stock grants and
warrants has become a standard component of most management compensation
packages. The management with a focus on the long term shareholder creation, rewards
on the basis of the company’s Economic Value Added (EVA).

1.3 BACKGROUND OF THE STUDY

Trading in the stock was mostly based on the intuition of the investorsprior to the
advent of computers. Also investors generally found it easier to follow a stock
and buy a popular stock. As trading flourished, people searched for tools and methods
that would increase their gains and minimise the risk. One major reason why the
importance of valuation had been created is that the activities in the stock markets
have increased. With many institutions and investors heavily invested, it called for an
ever increasing sophistication of tools available to estimate the value of firms in
the stock markets. When the book values of assets was more static and did not indicate
the future potential, it led to undervaluation of companies with high growth
potential. Distortions in
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valuation based on financial statements were possible as earnings can be inflated in the
short term due to the fact that accounting profits were subjective. Here, the
importance of free cash flows was stressed as free cash flows were ranked first in
the o rder of importance in comparison to accounting variables (Imam et al.,
2008). Hence, the current study emphasises the importance of carrying out the
valuation of firms using free cash flowin the FCFF (Free Cash Flow to the Firm)
method.

Information about a stock is normally incomplete, complex, uncertain and

vague, making it a challenge to predict the future economic performance. Hence, share
prices do not reflect the true value of the stocks. According to Dr.C.Rangarajan,
Former Governor of RBI, “Share price in India tends to be considerably influenced
by short term technical consideration and speculation.” Research evidence on the
Indian stock market shows that possibilities of undervaluation and overvaluation exist
for sizeable amounts of stocks. The current study makes a comparative analysis of the
extent of variation in stock prices from the intrinsic value under the three methods of
FCFF, EVA and RV(Relative Valuation).

Preference to income approach than the asset approach was given in the Indian
valuation context. The dominance of profits for valuation of share price was
emphasised in Mc Cathie’s Case as it was said that “the real value of the shares will
depend more on the profits the company is making and should be capable of making,
having regard to the nature of the business, than upon the amount which the
shares would realise on valuation.”

The Reserve Bank of India had prescribed DCF (Discounted Cash Flow) as the
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valuation method in the case of FDI (Foreign Direct Investment) investments after 21
April, 2010. In India, RBI is the only regulator which has mandated the use of
DCFin the case of ODI (Overseas Direct Investment) transactions and also for the
valuation of shares for convertible instruments. It also recommended the
comparable transaction method and PORI (Price of Recent Investment).

Valuation stresses the need for firms to generate positive earnings and
sales growth and also provide an adequate return on thecapital invested. The current
study uses returns, costs of capital and the present value concept in calculation of
firm’s value both under FCFF and EVA methods. Valuation enables investors to verify
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values rather

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than depend on brokers reports. The current study simplifies valuation with the use of
calculated multiples in the technique of Relative Valuation.

It is proved by the earlier researchers, that there was only a weak correlation
between how a firm performed by earnings and how the market appeared indifferent to
such growth in assigning a firm’s Price/Earnings (P/E). The goal of any
valuation method is to remove these distortions and to provide comparability over
time, firm and industries to meet the expectations of providers of capital. The current
study reduces such distortions by comparing the intrinsic values representing the
earnings of the firm with the actual market price.

Valuation is useful in circumstances such as mergers and acquisitions.

Valuation in an emerging market like India is gaining importance for joint ventures,
mergers and acquisitions, restructuring and value based management. The total
number of merger and acquisition deals of Indian companies in 2014 rose to 1177, the
highest ever in a decade and it was expected that the momentum would pick up in the
future years. The significance of valuation methods to determine the target price and
help in timing the sale of the business is invaluable in such circumstances. Business
valuation could impart insights into a company’s strengths and weaknesses. The current
study lays thrust on the methodologyto achieve the maximum selling price in an
acquisition.

1.4 PROBLEM DEFINITION

The heavy reliance on book value measures such as return on investment, return on
equity and earnings per share are subject to frequent distortions and manipulations
by the management. Investment made on these considerations did not consider
present values, cost of capital and cash flows. The valuation methods used in the study
incorporates these considerations like the use of present value in the determination
of the value of the firm and serves the principal users of the information like
Corporate Executives, Analysts and Money Managers. This kind of valuation
provides the requisite skill of looking at historic and forecasted information in
comparison to peers in the industry to determine whether the company’s stock is
overvalued or undervalued. Accurate valuation of the firm is most important and
can be identified by finding valuation errors. Hence, it is necessary to examine the
accuracy and bias of intrinsic equity prices estimated from the three valuation methods.
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Valuation errors would reveal

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which method yields a more accurate and unbiased price and would help choose
among the valuation methods.

The primary goal of investment is to earn returns above those made by

the market. In this direction, the study concentrates on the abnormal returns of the
stocks to verify the variables that have an impact on returns. This study would
enable to channelize investments into stocks with potential higher returns in the future.

1.5 RESEARCH QUESTIONS

The premise of this study is structured around the following research questions.

1. Is there any difference in the value of firms obtained by the select

methods namely Free Cash Flow to the Firm Valuation, Relative Valuation and
Economic Value Added and to determine the method that yields value closer to
the market price? Is there a significant difference in firm values of
multinational and domestic firms?

2. How can the values be verified for errors in practice? Can a single
valuation method be superior and lead to an unbiased and accurate price?

3. Do few multiples work better under Relative Valuation than the others?

4. Is the enterprise value of a firm positively affected by various drivers such

as fixed assets, working capital, employees, reinvestment rate, risk, and cost
of capital, return on capital, leverage, cash flow earnings and sales?

5. Are the abnormal returns of the stocks related to the intrinsic value of the
stock, market capitalisation and M/B ratio of the firm?

1.6 OBJECTIVES OF THE STUDY

1. To measure the intrinsic value of shares of the selected companies using

select methods and estimate the valuation errors arising from the
implementation of the select methods and to determine the proximity with the
market price.

2. To evaluate the value drivers that signifies the enterprise value of the firm.

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 3. To discriminate the domestic and multinational companies in terms of its
value and abnormal returns and to identify the significant determinants
influencing the enterprise value.

1.7 SIGNIFICANCE OF THE STUDY

In finance, calculation of present values of all cash inflows of the project is considered
in the determination of Net Present Value and this helped decision making on
acceptance or rejection of a project. The same concept could be applied to the firm as a
whole where valuation incorporated the present values of current and future cash flows
including the terminal value of the firm which arises with all future growth and
investment. To gauge the wisdom of investing in a company or a project where all the
company’s shares were acquired required consideration of all aspects of the firm in
totality. Value emphasis should be promoted as a part of corporate culture instead of
focusing on certain performance indicators alone like return on invested capital and
growth. Unlike previous studies with research centred mostly in developed countries,
this study is in the Indian context and aims to analyse the value of the firm through
important techniques like FCFF, EVA and RV. The study also attempts to establish the
proximity of the multiples to the market price.

The intrinsic value of the stock suggests the internal strength of the stock. But it
was not always true that the stock would achieve its intrinsic value in the stock market.
Hence in the current study the valuation of the firm and consequently its intrinsic
value is a technical suggestion to the investors to purchase the shares when they were
undervalued (market price < intrinsic value) and sell the shares when they were
overvalued (market price > intrinsic value).

The methods used to calculate the intrinsic value are verified to check the one
that gives values in proximity to the market price. The study also calculates the
enterprise and price value multiples using the technique of Relative Valuation. The
determination of valuation error is of practical importance. The study examines the
accuracy and bias of the intrinsic equity prices estimated from the three methods. The
results would be of help to an analyst, investor or researcher who has obtained the
firm’s financial statements and forecasts over a time horizon of firm’s earnings and
book values. During implementation of a valuation method, an accounting method
which would result in the most reliable intrinsic
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value has to be chosen. The study also tries to establish the impact of various factors on
the enterprise value of the company. The returns on the stock are also compared to the
market index to determine the abnormal returns. The abnormal returns are analysed for
its relationship with the Value/Price (V/P) ratio and also with the size of the company
(market capitalisation) and Market/Book Value (M/B) ratio to evaluate the type of
stocks that provide better returns. Thus, this research would help the management in the
structure and design of the variables like fixed assets, working capital and employees
costs.

1.8 APPROACHES TO VALUATION

There are numerous valuation methods which can be grouped under three
approaches to valuation.

• Intrinsic valuation
• Relative Valuation
• Contingent claim valuation

Intrinsic valuation could be further grouped into Discounted Cash Flow

(relies on cash flow) and non Discounted Cash Flow methods (relies on financial
variables other than cash flow). Some of the DCF techniques are Free Cash Flow to the
Firm (FCFF), Free Cash Flow to Equity (FCFE), Adjusted Present Value (APV)
and Dividend Discount Models (DDM). Intrinsic methods determine the value of a
firm using the pertinent factors as, capacity to generate cash flows from its assets in
place, its cost of capital, the expected growth rate of cash flows and the length of
the time it would take to reach stable growth.

Variants of non DCF techniques are Economic Value Added (EVA) and
Economic Profit methods, both being methods based on excess returns. These methods
highlighted how and when a firm creates value. Relative Valuation is based on the
market assessment of comparable firms with standardised measures of value. It
reflects market moods and perceptions better than FCFF and worked best for
investors with short term horizon. The third approach Contingent Claim valuation used
Option Pricing methods to measure the value of assets that has share option
characteristics. The idea is to estimate the correct theoretical price of the option
in order to determine its
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overvaluation or undervaluation. Knowledge of when to use a method is a key aspect
in mastering valuation.

1.9 CHOICE OF METHODS FOR VALUATION

A valuation system should also encompass the four main drivers of enterprise
value:
profitability, competition, growth and cost of
capital.

In the current study,FCFF, RV and EVA are adopted as they are frequently
used in the Indian context.The study evaluates each of the methods by means of
comparative analysis usingmarket prices as a benchmark for identifying over and under
valuation of the firm’s stock. The current study chooses the FCFF method as it is
independent of leverage and determines the company’s capability to pay off its debt
and equity claims. With its wide application by companies in India, EVA has been
selected for the current study as one of the methods for valuation of firms. The current
study also incorporates the use of Relative Valuation as a common and convenient
tool in the hands of an investor.

1.10 SCOPE OF THE STUDY

This study is limited to selected MNCs and domestic companies which are listed in the
Bombay Stock Exchange. Listing on exchange is a prerequisite since the stock price
information was needed for calculation cost of equity and also market capitalization.

This study is based on secondary data drawn from Prowess database of Centre
for Monitoring Indian Economy (CMIE). The study is restricted to the
companies selected considering the availability of data. The study has been carried out
with three methods of valuation but can be extended to other methods like Options
Valuation, Dividend Discount Models, and Free Cash Flow to Equity method and
Adjusted Present Value methods.

1.11 Definitions of terms used in the study

The thesis uses many terms and an explanation of the following terms is necessary
for understanding and application of the valuationmethods.

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1. Risk Free Rate (Rfr)

Risk free rate is the rate of interest payable on a long term bond issued by the Indian
Government. The risk free rate is reduced by the default spread for India which is
based on its local currency rate BAA3.

2. Cost of Debt (Kd)

Cost of debt of a company was calculated using the Synthetic default method by
adding default spread based on the company’s rating to the risk free rate. Once cost of
debt is calculated it is computed on after tax basis.

3. Tax Rate

The tax rate used is the tax rate provided by the Prowess database for the respective
domestic and foreign companies. The tax rate in the stable period is taken at a
uniform
30 percent.

4. Cost of Equity (Ke)

The study uses CAPM for the calculation of cost of equity capital which is equal to
the risk free rate and Beta times the Equity Risk Premium.

5. Equity Risk Premium (ERP)

Equity Risk Premium is taken from the calculations of Professor Aswath Damodaran,
India’s Equity Risk Premium has been computed with due consideration to the Country
Risk Premium.

6. Free Cash flow (FCF)

Free Cash flows one of the ingredients to calculate the value of the firm represented
the net cash flow of the company including non cash charges as reduced by other
planned expenditure such as capital expenditures and non cash working capital.

7. Non cash Charges

Non cash Chargesare items that affect the income but do not involve t he payment
of cash. The non cash charges included depreciation, amortisation and write offs which
are added to arrive at the FCF.The capital expenditures and changes in noncash

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working capital representedthe reinvestment needs of the firm for future growth.

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8. Capital Expenditure (CAPEX)

The capital expenditure of the companies includes purchase of fixed assets, increase in
capital work in progress and acquisition or merger of companies and units. For
estimating capital expenditures the study did not distinguish between internal and
external investments.

9. Non Cash Working Capital

Non cash working capital is computed as it has more relevance to valuation. It is

the sum of Inventories and Accounts receivable after the deduction of Accounts
Payable.

10. Growth

The annual growth in sales revenue is computed and the growth rate is averaged
from the years 2008 to 2013 and used for forecasting future growth of sales
during the explicit period of forecast for five years.

11. Explicit Period of Forecast

The explicit period of forecast is a period of five years from the year’s 2014 to
2018
which used a higher growth rate of sales.

12. Stable growth

The company is assumed to achieve its stable growth after five years when its
revenues grew at a lower rate not higher than the GDP growth rate of the economy.

13. Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital is the weighted average costs of market value
of equity and book value of debt. The calculated cost for three years is averaged and
its mean used to discount the cash inflows during the explicit period. The cost of
capital to discount the terminal values is calculated by lowering ERP by 1% and
cost of debt before tax by 1%.

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14. Terminal Value

A significant part of the company’s value can be derived from its terminal value
which is calculated during the period of stable growth, discounted and added to
calculate the Enterprise Value.

15. Beta

Beta measured the unsystematic risk of the company. This beta has been unlevered
and levered in the calculation of cost of equity.

16. Enterprise Value (EV)

The enterprise value is the total value of the company that includes the debt and
equity components.

17. Equity Value

Equity value represents the claims of the equity stakeholders by deducting debt and
adding cash and cash equivalents.

18. Intrinsic Value

From the equity value, value per equity share or intrinsic value is computed to be total
equity value divided by the total number of shares.

19. Discounted cash flow (DCF)

DCF techniques estimate the intrinsic value of an asset based on the present values of
cash inflows during the explicit period of forecast and the present value of
terminal value calculated in the last year. The cash inflows are discounted using
the cost of capital reflecting the riskiness of the cash inflows.

20. Free Cash Flow Firm (FCFF)

Free cash flow to the firm is a method which calculates the value of the firm based on
free cash flows representing the total flows to both debt and equity shareholders. The
FCFF method used in the current study has two stages of growth, the explicit period of
high growth and period of stable growth.

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21. Economic Value Added (EVA)

EVA measures the true economic profit and is calculated on the net operating
profit after tax after deducting the costs of all capital.

22. Invested capital

The total invested capital is computed under EVA for each year as equal to the Book
value of Equity Capital and Book value of Debt.

23. Return on Capital

The Return on Capital is equal to earnings before interest and taxes divided by the
book values of capital debt and equity. The Return on Capital (ROC) has to be higher
than the firm’s cost of capital for the enterprise to create a larger value.

24. Reinvestment Rate

The sum of capital expenditures and changes in non cash working capital represent the
reinvestment needs of the firm for future growth. From the above calculation,
depreciation is deducted and divided by EBIT.

25. Relative Valuation(RV)

Valuation of an asset is based on standardised values of similar or comparable assets.

To facilitate comparison the companies are chosen from the same industry. Relative
Valuation of companies had been done using enterprise and equity multiples.

26. Abnormal Returns

The abnormal return for a stock is the excess returns made by each company’s
stock
over the market index SENSEX.

1.12 LIMITATIONS OF THE STUDY

The study is restricted to a sample size of thirty two companies due to time and
financial constraints. Non availability of financial information of MNCs in the
Prowess database has been a constraint in the collection of information pertaining to

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these companies. The

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database provided information on only few MNCs and the need to have parity between
domestic and MNCs restricted the sample size to thirty two. Moreover, these
companies are not required to be listed as per SEBI’s current guidelines due to which
pricing information is unavailable for many of these companies.

The select methods used also require voluminous information which is spread
across twenty five statements for each company. Hence, the restraint on the availability
of secondary data limited the sample size.

1.13 ORGANISATION OF THE STUDY

The first chapter of the thesis describes the need, objectives and scope of the study.
The second chapter provides previous research studies focussed on the area. The
third chapter outlines the methodology for calculation of the cost of capital, the
intrinsic value using the three methods, valuation errors and abnormal returns. The
fourth, fifth, sixth and the seventh chapters analyses the results of the study. The
eighth chapter concludes the study with suggestions and recommendations.

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