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OLD FORMAT
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NEW FORMAT
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NEW FORMAT
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Valuation - Reality
1. We can only estimate a likely range of fair value, never a
precise estimate an endless search for intrinsic value
2. A professional valuation report usually has inherent biases
depending on who is valuing and for whom
3. Uncertainty is a given in business valuation
4. High end quantitative techniques are not necessarily better
valuation models in fact simpler models give better
estimates
5. Herd mentality tends to reinforce biases and perceptions
which may be distant from reality
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PV Basics
1. PV of series of cashflows at time t 0
CFn
CF1
CF2
.
.
.
(1 r )1 (1 r ) 2
(1 r ) n
2. PV of a constantperpetuity at time t
CFt 1
r
(1 g) n
1
n
(1
r)
5. PV of a growing year end annuity; PV(A, n, r, g) A(1 g)
r-g
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Testing PV Basics
A business currently earns $10mn and this is expected to grow at
5% per year for the next five years and thereafter remain constant
at $15mn per year for another 5 years. From the 11th year onwards
earnings are expected to grow at 5% till perpetuity. Find the value
of the business by discounting earnings at 10%
(1 (1.05 / 1.1) 5 )
1
(1 (1 / 1.1) 5 )
10 * (1.05 )
* 15
n
0.1 0.05
0
.
1
(1.1 )
1
(1.1
15 * (1.05 )
(0.1 0.05 )
10
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Capital
Networth (NW)*
If Calculated From Equity and Liability Side = Share Capital + Reserves
& Surplus
If Calculated from Asset Side = All assets Non-Current and Current
Liabilities
Capital Employed or Invested Capital**
If Calculated From Equity and Liability Side = Networth + Debt (Long
and Short Term) + Short term portion of Long term debt (we have to look
at details of other current liabilities to get this figure)
* Many analysts include deferred tax liability (DTL) as part of NW. This is true is cases
where DTL is expected to exist for a very long time. Otherwise DTL should be part of
Long Term Debt. But ensure it is treated as either debt or equity and not left out.
** When investors look to calculate return on total capital, the total capital they take is
equity plus interest bearing debt (including short term portion of long term debt).
Liabilities which arise in the course of business (long or short term) are not part of
invested capital. Hence Current Liabilities (CL) and other long term liabilities are not
included as part of it other than short term portion of long term debt.
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Intrinsic Value
Market Value
Book Value
Market Price
The terms market price and market value are interchangeably used we use the
term market value more when we talk of the value of the aggregate company and
use the term market price more when we talk of the price per share
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So
If someone asks you what is the value of company A, you
ask him/her which of the following value they are
referring to:
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Return on Equity
Choose the correct answer:
RoEt = PATt / Net Wortht
RoEt = PATt / Net Wortht-1
RoEt = PATt / Average Net Worth(t,t-1)
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Return on Equity
Choose the correct answer:
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On the P/L
We want to make adjustments for:
Non recurring items
Separate out the core and non-core income, expenses and
taxes.
Also to reflect average normal income from the assets of the
company, we may adjust for capacity utilisation, business
cycle etc.
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Infosys RoE
From Database
Actual
Even though the above nos of RoE from a database seem to indicate that infosys RoE is
about 27% that is actually its blended RoE of operating and non operating income. In the
balance sheet of Infosys in year 2011 there was almost 16666 crore cash and
equivalents. Out of this total of cash and cash equivalents lets consider about 1666
crores as cash required for operation. So the balance 15,000 crore was excess cash.
Total Networth in 2011 was 25976 crores. So operating networth will be only about
10976 crores after subtracting excess cash. Also PAT of infosys for year 2012 was 8332
crores. Other income was 1904 crores (mostly interest income from excess cash) and
hence post tax other income would be just 1904*(1-0.3) or 1332 crores. Hence operating
PAT is (8332-1332) = 7000 crores. Hence true operating RoE on opening equity capital
is 7000/10976 or almost 63% !! Infosys has no debt so RoIc = RoE
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Infosys RoE
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Solution
The reported PAT of a company is 500 mn. An analyst is trying to normalize
this PAT. The tax rate on ordinary profits is 50%. He notices that the P&L
statement had a one time income of 100 mn on which the tax rate was only 20%
and he has to adjust the reported PAT for this line item in order to calculate
normalized PAT. Apart from this all others items on the income statement were
normal in nature and need no further adjustment. What is the normalized
PAT of the company?
Solution:
One time item to be excluded: 100 mn
Tax on this item: 100*0.2 = 20 mn
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Solution
In 2006 Apollo Hospitals Ltd reported a PAT of 50 crores. As part of operating
expenses it showed an expenses of 15 crores on accreditation. In notes to
accounts it mentioned that such accreditation was valid for 3 years and the
company will look to renew it after 3 years. This is a tax deductible expense.
The marginal tax rate of AHL is 30%. What should be normalised PAT for
2006?
Solution:
The 15 crores should be spread over 3 years and hence only 5 crores should
have been expense for this year.
Hence normalised PAT = 50 + 15*(1-0.3) 5*(1-0.3) = 57 crores or 14% higher
than reported
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Future opportunities
Amount retained out of earnings
Additional investments
The return generated on these investments
Part growth may be due to inflationary effects zero value growth
Part growth may be due better utilization of existing assets - not sustainable
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We can see from above formula that Growth rate cannot exceed
RoE since maximum retention ratio is one (assuming no external
capital brought in). Hence if a company wishes to grow at a rate
faster than its sustainable RoE it needs to keep raising and
investing capital in excess of its PAT i.e. raise new funds
Limitations of EPS growth formula
Focuses on per share number
Assumes reinvestments will generate returns at RoE
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Changing RoC :
gNOPLAT = reinvestment rate*RoNIC + [(RoNIC RoIC) / RoIC]
When the return on capital is changing, there will be a second component to
growth, positive if the return on capital is increasing and negative if the return
on capital is decreasing.
If the change is over multiple periods the second component should be spread
over each period
RONIC this is the new overall RoIC after new capital is invested
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Example
Data : Current year is 2012
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Question 1
Question 1: What is growth rate of PAT in 2013 if RoE
can be maintained in future
Solution: Method 1 using formula
RoE 2012 = PAT 2012 / NW 2011 = 0.2; hence NW 2011 = 500
Since additional NW in 2012 is 50 the reinvestment rate is
50/100 = 50% or 0.5
Since this is a case of stable future RoE
expected growth rate in earnings = 0.5 * 0.2 = 10
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Question 2
Question 2: What is growth rate of PAT in 2013 and
2014 if RoE next year and beyond can be maintained at
30%
Solution method 1 using formula
Gnet income= equity reinvestment rate *RoEt+1 +[(RoEt+1 RoEt)/
RoEt]
reinvestment rate in 2012 = additional investment / PAT = 50/100
= 0.5 or 50% - data says this will also be same in future
Hence g 2013 = 0.5*0.3 + (0.3-0.2/0.2) = 0.15 + 0.5 = 0.65 or 65%
In 2014 the RoE will be same as was in 2013, hence g 2014 =
RoE*RR = 0.3*0.5 = 0.15 or 15%
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Question 2
Question 2: What is growth rate of PAT in 2013 and 2014 if RoE
next year and beyond can be maintained at 30%
Solution method 2 from basics
NW 2011 = PAT 2012 / RoE 2012 = 500
reinvestment rate in 2012 = additional investment / PAT = 50/100 = 0.5 or
50% - data says this will also be same in future
NW 2012 = NW 2011 + change in NW = 500 + 50 = 550
RoE 2013 = 30% - given: hence PAT 2013 = 0.3*550 = 165
g 2013 = (165 100)/100 = 65%
Reinvestment in 2013 = PAT 2013 * reinvestment rate = 165*0.5 = 82.5
NW 2013 = NW 2012 + 82.5 = 632.5
PAT 2104 = RoE 2014 * NW 2013 = 0.3 * 632.5 = 189.75
Hence g 2014 = (189.75-165)/165 = 0.15 or 15%
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Efficient Markets?
Rational Investors?
Inefficient Markets?
Irrational Investors?
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Efficient Markets?
Rational Investors?
Inefficient Markets?
Irrational Investors?
Markets are a mix and match of all of the above at ANY given
point in time the purpose of valuation is to figure out how
investors and markets SHOULD be pricing securities as
against what they ARE pricing them at
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Ja
n9
Ju 9
n9
No 9
v9
Ap 9
r- 0
Se 0
p0
Fe 0
b01
Ju
l-0
De 1
c0
M 1
ay
-0
O 2
ct
-0
M 2
ar
-0
Au 3
g0
Ja 3
n0
Ju 4
n0
No 4
v0
Ap 4
r- 0
Se 5
p0
Fe 5
b06
Ju
l-0
De 6
c0
M 6
ay
-0
O 7
ct
-0
M 7
ar
-0
Au 8
g0
Ja 8
n0
Ju 9
n0
No 9
v0
Ap 9
r- 1
Se 0
p1
Fe 0
b11
Ju
l-1
1
Value
800
700
Div Yield
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Earnings
Book Balue
600
500
400
300
200
100
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Sources of Value
And their link to the competitive
position of the firm
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Competitive Advantages
1.
2.
3.
Cost Based
1.
4. Economies of scale
1.
2.
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Terminology
RCA
LV
EPV
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Sources of Value
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2. EPV = RCA
No competitive advantages; average management
Ignored growth but in a situation with no comp adv growth doesnt add value
because RoIC = r !!
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Growth Multiplier
M = EPVgrowth / EPV
= [1 (g/r)(r/RoIC)] / [1- (g/r)]
The higher the (g / r) and lower the (r / RoIC) greater the value of
growth
R/r
g/r
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1.5
2.5
0.25
1.11
1.17
1.2
1.22
0.5
1.33
1.5
1.6
1.67
0.75
2.5
2.8
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EPV
Franchise
Value from
current
competitive
advantage
Value of
Growth only
if growth
within
franchise
Asset value
Reproduction
Cost
Free entry
No comp adv
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Equity DCF
Use free cash flows to Equity holders (FCFE)
These are cash flows from assets after debt payments and after meeting reinvestment needs
The discount rate would reflect the cost of equity (CoE)
Various data bases and books differ in the way they define Free
Cash Flows the essence rather than technical definition is
important
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FCFt 1
(this is the PV formula for growing perpetuity whereFCF t 1 FCFt * (1 g) )
WACC g
NOPLATt 1 * (1 IR)
WACC g
g
)
RONIC
WACC g
This can be rewritten as ICt*(RONIC-g) / ( WACC-g),
where RONIC is the ROIC expected for next year
NOPLATt 1 * (1
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FCFt 1
WACC g
NOPLATt 1 * (1 IR)
WACC g
NOPLATt 1 * (1
WACC g
g
)
ROIC
g
)
ROIC IC ROIC g
0
WACC g
WACC g
IC0 (ROIC) * (1
IC0
IC0
ROIC WACC
IC0
WACC g
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Calculations
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Terminology
Economic
Profit
Residual
Earnings
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1. Calculate Economic Profit (EP) for year 2011. WACC = 10%, t=30%
2. Calculate Residual Earnings (RE) for year 2011. CoE = 12%,
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Solution process
Step 1 calculate NOPLAT
Step 2 calculate RoIC and RoE
Step 3 calculate Economic Profit and Residual
Earnings
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Solution
EBIT 2011 (PBT+ interest)
20100
NOPLAT 2011
14070
IC 2010
92800
WACC
0.1
0.151616
PAT 2011
10920
Networth 2010
37800
CoE
0.12
0.288889
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What is
Valued
Discount
Rate
Basis
What to
Discount
Enterprise DCF
(FCFFM)
Operating CFs
Equity DCF
(FCFEM)
Equity
Cash Flows
CFs to Equity
Economic Profit
(EPM)
Accrual Accounting
Economic Profit
Residual Earnings
(REM)
Equity
Levered
CoE
Accrual Accounting
Residual
Earnings
Dividend Discount
(DDM)
Equity
Levered
CoE
Cash Flows
Dividends
Adjusted Present
Value (APVM)
Cash Flows
Operating CFs
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Levered
CoE
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t n
FCFFt
FirmValue
t
t 1 (1 WACC )
t n
FCFE
FCFE t
Equity Value
t
(
1
CoE
)
t 1
t n
DDM
APV (MM
Theorem)
Div t
EquityValue
t
(
1
CoE
)
t 1
APV = PV of FCFF + PV of tax shields PV of bankruptcy cost =
FCFF (for FCFF use unlevered CoE as discount rate / for tax shields
its cost of debt or unlevered CoE)
All Models (other than DDM) will give the same value. Equivalence will hold IFF you make
consistent
assumptions
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IC t ( ROIC t 1 WACC t 1 )
FirmValue IC 0
t 1
(
1
WACC
)
t 0
Residual
Earnings
Model
CoE
)
t 0
t n
t n
Accrual Accounting Models Should give same value at Cash Flow models if assumptions are
consistent
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