Projecting Financials &

Valuation

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 Agenda
• Management Interaction
• Projecting Financials
– Estimating Growth
• Estimation of Discount Rates
• Estimation of Cash flow
• Valuation
– Discounted Cash flow Analysis
– Relative Valuation

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 Agenda
• Valuation
– Valuation of Mergers and Acquisitions
– Choosing the right valuation tool
– Market Perspective on Relative valuation
– Giving Recommendation
• Analyzing Financial Services Companies

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 Management Interaction
• Futuristic Questions
• Focused on the broader areas that give you sense of what
lies ahead
• Strategy:
– Plans of entering into new businesses
– New client acquisition
– Technology & its impact on the business & margins
– Inorganic acquisition
– Market share strategies
– Rationale behind new geographical forays
– Etc.

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 Management Interaction
• Finance
– Expected growth in revenue (management may
not always tell this, so indirect questions asking
the same in like will you grow at minimum of
industry growth rate, etc.)
– View of margins and factors affecting it
– Any funding plans, ways of funding
– Pricing strategy
– Volume etc.

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 Projecting Financials
• Building the revenue model
– Identifying the key revenue drivers
• Identifying the Volume measure
• Identifying the Pricing measure
• Business model
• Should be most comprehensive
• Nature of the business
– For e.g. in IT sector there are multiple drivers
• Geographical breakup (US, Europe, India and RoW)
• Location of work: Onsite-Offshore
• Service Lines
• Domains of work etc.
• Key driver, however, is the employee base. How?
• Building the Infosys revenue model.

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 Projecting Financials
• Key revenue drivers in different industries
– Telecom
– Real Estate
– Infrastructure
– Automobile
– Auto ancillary
– Banking
– Media
– FMCG
– Retail & Hospitality

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 Projecting Financials
• Building Cost Models
– Identifying the key costs
• Direct costs
– Labor
– Material
• Basis for projecting:
– Capacity expansions, if any
– New geographical forays (lower labor costs, availability material etc)
– Acquisitions etc.
– Also see the trends expected in the raw material prices.
• Indirect Costs
– Selling and Marketing Expenses
» Need to verify the market & economy scenario
» Look at the historical trends and see any cyclicality
– General & Administration Expenses

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 Projecting Financials
• Depreciation: Always project the Depreciation
as a % of average gross block.

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 Projecting Financials
• Projecting the Other Income
– See the schedules to get the break up of the other income.
It typically comprises:
• Interest on deposits (Cash & Bank Balance)
• Dividend on investments (Liquid investments like MF, others
etc)
• Others
» Typically, project the entire other income based on the cash, bank
balance & liquid investments

• Projecting Interest Expenses: as % of the loan

• Extraordinary Income: Do not project unless you have
high level of conviction about it arising.

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 Projecting Financials
• Taxes: Project the taxes based on the
management discussions and as % of PBT.
• Minority Interest: Ideally, you should project
the numbers of the subsidiary and consolidate
it with the parent company. However, if the
subsidiary is not big enough, project minority
interest as % of PAT (before Minority iterest)

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 Projecting Financials
• EPS
– Projecting the Number of Shares
• Factor in the issue of new shares
• ESOP conversion
• Factor in what proportion of the debentures will get
converted into equity shares
– Inputs from management will be quite valuable
for projecting the diluted EPS.

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 Projecting Financials
• Dividends: The company board decides the dividends.
Typically, the companies in growth phase would give
lower dividends and those in mature phase will give
higher.
• Dividends can be projected as % of PAT or as % of Equity
Capital. Always get feedback from the management as to
what do they refer internally.
• Typically, the companies will not lower the dividends as it
is considered a major negative unless it is able to justify
the investors the reason for lowering the dividends.

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 Projecting Financials
• Equity Capital: Equity capital will go up because of:
– Convertible got converted:
• Adjustments:
– ESOP issued:
• Adjustments
– Issue of Bonus:
• Adjustments:
– Share Split:
• Adjustments:
– Share Buyback:
• Adjustments

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 Projecting Financials
• Projecting Loans:
– Loan Repayment Schedule

– Factoring in New Loan

• Always keep a close tab on the Debt to Equity
• Minority Interest

• Deferred Tax Assets & Liabilities

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 Projecting Financials
• Gross Block
– Project Capital Expenditure:
• get inputs from the management
• See the expansion plan
• See historical trend in capex per key parameter (number of
user, towers, customers, employees, etc.)
• Have some basis like revenue target, market share target,
etc.
• Get cues from the announcements done by the
management etc.
– Next Year Gross Block = Last Y Gross Block + Capex

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 Projecting Financials
• Accumulated Depreciation:
– Last year Accumulated Depreciation + Current
year Depreciation
• Computing Capital Expenditure:
– Increase in Gross Block + Increase in Capital Work
in Progress + Increase in Goodwill
– Increase in net block + Current year Depreciation +
Increase in Capital Work in Progress + Increase in
Goodwill

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 Projecting Financials
• Current Assets:
– Debtors
• Calculate the debtor days. Look at historical trends. Look at
the current market trends. Look at the competition. See
how is company placed vis-à-vis in the coming days. Check
new product launches, if any. Have some rationale
assumptions over their success rates. Based on that predict
whether the company will be more aggressive or liberal.
– Cash has to be the balancing figure. Look at the value
of cash. If it is fluctuating by great value, get that
there are other assumptions that are getting wrong.

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 Projecting Financials
• Inventory
– Calculate the inventory days. Interact with the
management. See the market scenario. Have a
view on the demand-supply scenario. Based on
that project the inventory.

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 Projecting Financials
• Creditor Days:
– Calculate the creditor days based on (typically)
total costs involved. It should ideally be calculated
on the net purchases. However, if the creditors
involve all sorts of entries, it should be calculated
on the total operating costs/ total direct costs.
– With the best judgment of whether the company is
in position to ask for higher credit period, project
the creditor days and reverse calculate the
creditors.

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 Projecting Financials
• Provision for Dividends:
– Project it as % of the total dividends paid
• Provision for Taxes
– Project it as % of the total taxes paid
• Other provisions: See its relevance for the
balance sheet. See how big is the value.
Identify the proper driver for it and project.

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 Projecting Financials
• Projecting For next 5 years
– It is a difficult task indeed. However, you need to
foresee and make the rationale assumptions.
– One of the ways could be to assume that the
company will maintain the same market share in
the industry. And using the industry forecasts that
are publicly available. But you must be able to
support your assumptions with other solid data.

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 Projecting Financials
• Some basic principles:
– Always take the denominator figure as the average
of last two years.
– Always keep a tab on the common sized P&L and
Balance sheet to see whether your projections are
going haywire.
– Do not waste too much time on one entry at a time if
the projected number does not make much of a
sense.
– Not all things will ever be clear for you

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 Estimating Growth
• Types:
– Look at the firm’s past earnings i.e. its historical
growth rate
– Looking at the analysts growth estimates
– Fundamental growth of the firm from its
reinvestment

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 Estimating Growth
• Historical Growth
– Arithmetic Versus Geometric Averages
– Linear and Log-linear regression models
– Time-series to model EPS
– Usefulness of Historical growth
– Revenue growth Vs Earnings growth
– Effects of Firm size
– Example

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 Estimating Growth
• Analyst Estimates
– What gets covered?
• High market capitalization
• Institutional Holding
• Trading Volume
• What is different about the analyst forecasts?
– Firm specific information that has been made public since the last
earnings report
– Macro economic information that may impact future growth
– Information revealed by competitors on future prospects
– Private information about the firm
– Public information other than earnings

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 Estimating Growth
• Fundamental Determinants
– Growth = Function ( Reinvestments & its quality)
gt = (NIt- NIt-1)/ NIt-1

gt: Growth rate in net income

NIt :Net income in year t
By Definition:

NI(t-1) = BV(t-2) *RoE (t-1)

NIt = BV(t-2) + Retained Earnings (t-1)*

RoE t

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 Estimating Growth
• Fundamental Determinants
Assuming RoEt=RoEt-1=RoE

gt = (BVt-2 + Retained Earnings t-1-BVt-2) NIt-

1*RoE
= Retained Earnings t-1/ NIt-1*RoE
= b * RoE
Where b is retention ratio.
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 Free Cash Flow Models

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 Valuations
• Three Basic Questions
– Why do you value a Company?
– What do you value in the company?
– How do you value a company?

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 Valuation
• Why do you value a company?
– To arrive at the decision on Buy or Sell shares of a
company
– To assist you in evaluating whether the value is
getting created or not
– To identify the merger or acquisition target
– To value the synergy post merger/ acquisition

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 Valuation
• What do you value in the company?
– You can value inventory
– You an value the project the company has taken
up
– You value the corporate bonds
– You can value the managers (value manager)
– You can value Equity of the company
– You can value the entire firm itself

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 Valuation
• Approaches to Valuation
– Discounted Cash Flow Valuation
• Dividend Discount Models
• Free Cash flow to Equity Models
• Free Cash flow to Firm

– Relative Valuation
• Price/ Earnings Multiple
• Price/ Sales Multiple
• Price/ Book Value Multiple
• EV/ EBIDTA Multiple
• EV/ Sales Multiple

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 Valuation
• Discounted Cash Flow Valuation
– This implies that discounting the future cash flow
at a discounting rate.
– So, the next obvious question is at what discount
rate.

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 Valuation
• Computing Discount Rate
– It is also called as Expected Rate of Return (ERR)
– If you are valuing an equity, it is called as cost of
Equity.
– If you are valuing debt, it is cost of debt.
– If you are valuing a firm, it is called as Cost of
Capital.
– So, how do you compute it?

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 Valuation
• Computing Discounting Rate
– CAPM
• CoE = Rfr + Beta * (Rm –Rfr)
• Rfr is a risk free rate
• Beta is the measure of the covariance of stock returns with that of
the market index
• Rm is market return
• The equation is based on several Assumptions:
– Investors have homogeneous expectations about asset returns and variances
– They can borrow and lend at risk free rate
– There are no transaction costs
– There are no restriction on short selling

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 Valuation
• Computing Discounting Rate
– CAPM
• Risk premium (Rm-Rfr) is the difference between the average
stock returns and the returns on the risk free securities.
Typically, the use of longest period seems appropriate.
Moreover, the use of geometric mean rather than arithmetic
mean takes care of the compounding effect.
• Risk premium can vary depending on a. variance in underlying
economy b. Political risk c. Structure of the market.
• In country like India typically the risk premium is assumed to
be between 7-8%.

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 Valuation
• Computing Discounting Rate
– CAPM
• Risk Free Rate
– A short term T-Bill Rate
– Current short term government security rate
– Current long term government-bond rate
– In most valuation cases, the risk free rate that is considered is
the one for long term government bond rate.
– In India the long term government rate is: xxxxxx

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 Valuation
• Computing Discounting Rate
– CAPM
• Beta: There are 4 points that need to be considered
while estimating Beta.
– Length of Estimation Period: A long period provides more data
but the firm itself might have changed in its dynamics.
Typically, a 5 years of data is advisable
– Return Interval: Daily, Weekly, Monthly, etc. Non-Trading bias.
Weekly, Monthly data is advised as it helps removing non-
trading periods.
– Choice of Index
– Errors involved in computing Beta.

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 Valuation
• Computing Discounting Rate
– CAPM
• Determinants of Beta
– Type of Business: Cyclical businesses have higher betas. Beta
of a firm operating in different businesses will have betas that
are weighted average of betas of the respective business lines.
– Degree of Operating Leverage: A degree of operating leverage
is function of the cost structure of the firm and is usually
defined in terms of the relationship between the fixed costs
and the total costs. The firm that has higher operating
leverage, i.e. higher proportion of fixed costs in total costs will
have higher variability in EBIT

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 Valuation
• Computing Discounting Rate
– CAPM
• Determinants of Beta
– Degree of operating Leverage: Firms A&B. Firm A has 40% of
its costs variable and firm B has 60% of its costs variable. For
expected revenue of Rs125mn, Boom revenue of Rs200mn
and recession revenue of Rs80mn, the EBIT will be as follows:
Costs in Rs mn EBIT in Rs mn
Fixed/
Firm Fixed Variable Total Expected Boom Recession

A 50 50 0.5 25 70 -2

B 25 75 0.25 25 55 7

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 Valuation
• Computing Discounting Rate
– CAPM
• Determinants of Beta
– Financial Leverage: Other things remaining equal, increase in
financial leverage will increase the equity beta of a firm.
Intuitively, increase in the payment of interest expense will
increase the earnings during the boom time and would impact
badly during recession. If the having debt on the balance
sheet is giving tax advantage to the firm, then the Beta can be
computed as:
– BetaL = BetaUL *(1+(1-t)*(D/E))
– Computing Unlevered Beta Assignment.

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 Valuation
• Computing Discounting Rate
– Arbitrage Pricing Model (APM)
• This is used to have further accurate estimate of the
cost of Equity.
• It is given by
j=n

CoE= Rfr + ∑ Betaj * (E(Rj)-Rfr)

j=0

Where Rj is the return on every factor j having Betaj

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 Valuation
• Computing Discount Rate
– According to Grodon Growth model,
• P0 = DPS1/ (Ke- g)
So, Ke = (DPS1/ P0) + g

However, using this Ke will always justify the current

price given that is has been computed from the
same.

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 Valuation
• Computing Discounting Rate
– Weighted Average Cost of Capital

WACC = E/ (E+D) *Ke + D/(E+D) *Kd

* Value Equity and Debt at the market value not at book value

– Computing Cost of Debt, Kd

• Current level of interest rates: Typically, as the level of interest rates
increases, the cost of debt also increases.
• Default risk of the company: As the default risk of the company
increases, the Kd also increses. If the ratings go up, the Kd will reduce
and vice a versa. If the ratings are not available, use the recent interest
rates paid by the firm.
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 Valuation
• Computing Discounting Rate
– Computing Cost of Debt, Kd
• The tax advantage with the debt: As the interest paid
on the debt is tax deductible, the after tax cost of debt
will be lower than the pre-tax cost of debt.
• After Tax Kd = Pre-tax Kd *(1-t)

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Investor in a firm are entitled to get residual cash flows
from the firm after meeting its all the obligations,
including debt payments and after meeting the
reinvestment needs of the organization. So, the cash
flow remaining after operating expenses, interest and
principal payments, and any capital expenditure
needed to maintain the growth rate in projected cash
flow.

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Unlevered Firm
Revenues – Operating expenses
= EBITDA
- Depreciation & amortization
= EBIT- Taxes
= Net Income + Depreciation & Amortization
= Cash flows from operations – Capital Expenditure – working capital
needs
= Free cash flow to equity

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Unlevered Firm
– The Free cash flow to equity can be negative. In that case, the
company needs to come up with the new issue or private
companies need to raise funds from the owners or the
venture capitalists. It can be positive and dividends can be
paid, though not always.
– Depreciation: It is a non-cash expenses and also tax
deductible. They provide tax benefit to the extent of:
Depreciation * marginal tax rate

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Unlevered Firm
– Capital Expenditure: A portion of the operating cash flow has
to be invested in maintaining the existing assets and to create
new growth assets. Since the benefits of the growth are
usually reflected in cash flows, so we need to reflect the costs
incurred to create the growth assets in the cash flow.
– Relationship between Capex & Depreciation: Firms in high
growth phase have capex that exceeds the depreciation.
While for the firms in stable growth phase, capital
expenditure and depreciation are at par. This implies that the
ratio of capex to depreciation should decline as the firm
moves from high growth to stable growth phase.
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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Unlevered Firm
– Working Capital requirements: Since the funds tied up in the working
capital can not be used anywhere else, they have to be considered
while computing the cash flow.
– Increase in working capital are cash out flows and decreases are cash
inflows.
– Treatment of cash: By definition, the cash is included in computation of
working capital. However, if the cash is not being used for the day to
day operations of the company, it should not be considered in
computation of working capital. Typically, 2-3% of sales can be
considered as normal cash. Mere increase in cash can not be
considered as cash outflow.
– Higher the growth, typically, higher will be the working capital needs.
WC needs also change from business to business.
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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Levered Firm (Optimal D/(D+E) Ratio)
Net Income
+ Depreciation & Amortization
= Cash flow from operations –Capex
- Working capital requirements
- Principal Payments
+ Proceeds from new debts
= Free cash flow to equity
• Here it is assumed that the principal payments will be done from
the new debt issues.

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Levered Firm (Optimal D/(D+E) Ratio)
• And hence,
Net income
– (1-D/(D+E)) * (Capex- depreciation)
– (1-D/(D+E)) * Working capital changes
= Free cash flow to equity

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Levered Firm (Below Optimal D/(D+E) Ratio)
– In this case, the firm will issue debt to take its debt ratio to the
desired targeted debt ratio, ∂.
– Here, proceeds from the new debt will be greater than:
Principal Payments + ∂ * (Capital Expenditure + Working Capital
needs)
– Example

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 Valuation
• Estimation of Cash flows
– Cash flow to equity
• Levered Firm (Above Optimal D/(D+E) Ratio)
– Here, the firm may have to generate disproportionately higher
equity in financing its investments needs to reduce its debt
ratio. It may have to generate funds to repay its principal.
– Here, proceeds from the new debt will be lower than:
Principal Payments + ∂ * (Capital Expenditure + Working Capital
needs)
– Example

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 Valuation
• Estimation of Cash flows
– Cash flow to Firm: In general terms the cash flow to
the firm are the earnings after operating expenses
and tax but before paying to any claim holders.

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 Valuation
• Estimation of Cash flows
– Cash flow to Firm
Claim Holder Cash flow to claim holder Discount Rate
Equity Investor Free Cash Flow to Equity Cost of Equity
+
Debt Holders Interest Expenses (1-t) + After Tax
Principal Payments Cost of Debt
- New Debt Issues

Preferred Stock Holders Preferred Dividends Cost of Preferred Dividends

Firm = Equity Investors + Debt FCFF= Free Cash Flow to Weighted Average Cost of
Holders + Preferred Stock Equity + Interest Expenses (1- Capital
holders tax rate) +Principal
Repayments – New Debt
issues + Preferred Dividends

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 Valuation
• Estimation of Cash flows
– Cash flow to Firm:
• The other way is to compute
• EBIT (1-t) + Depreciation – Capital Spending –WC Needs

• The cash flow to firm is generally greater than the cash

flow to equity and is equal to it in case of the unlevered
firm.
• Now, let us turn our attention to free cash flow models.

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 Valuation
• Discounted Cash Flow Models
– Dividend Discount Models
• When individuals buy stocks, they expect returns in terms of the
expected dividends and the appreciation of the stock price.
• So, the hypothesis is that the price itself is the function of the future
expected dividends till infinity.
j=n

Price = ∑ DPSj / (1+r)j

j=0

DPSj is expected Dividend per share.

r is required rate of return on the stock.
• To identify the future dividends, the assumptions for the future
growth rates in earnings and payout ratios are made.

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 Valuation
• Discounted Cash Flow Models
– Dividend Discount Models (DDM)
• CAPM is used to identify required rate of return and
assumptions about different variables like Beta,
Riskfree rates are made.
– Versions of the DDM
• Gordon Growth Model
• Two Stage DDM
• Three Stage DDM

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 Valuation
• Discounted Cash Flow Models
– DDM
• Gordon Growth Model
• Value of Stock = DPS1 /( r- g)
– DPS1 is Dividend per share for next year
– R is required rate of return for equity investor
– g is perpetual growth rate
Stable Growth rate
6
5
4
g%
3
2
1
0
FY10 FY11E FY12E FY13E FY14E FY15E

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 Valuation
• Discounted Cash Flow Models
– DDM
• Estimating stable growth rate
– As the dividend is expected to grow at a stable rate forever, firm’s
other measures are also expected to grow at same rate. For if, the
dividends grow at a higher rate (say 8%) than earnings (say 6%), over
the years, dividends will exceed the earnings. In the reverse case, the
dividend payout will converge to zero, which is not a steady state.
– The expected growth rate can not be greater than the economy’s
nominal growth rate as, if it continues, the company will be bigger
than the economy over the years, that is quite irrational. Hence the
stable growth rate should be around the economy ‘s nominal growth
rate.

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 Valuation
• Discounted Cash Flow Models
– DDM
• Estimating stable growth rate
– In country like India, the nominal growth rate in the economy
in the long term will be say 2-3% with expected inflation of 4-
5%. So, the stable growth assumption should vary too much
from 6-8%. The growth rate can not be more than 1-2% above
the growth rate in economy.
• Limitations of the Model
– It is extremely sensitive to the input of growth rate.
• Example

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 Valuation
• Discounted Cash Flow Models
– DDM
• Two Stage DDM
– Here, it is estimated that the growth happens in two stages.
– First few years of higher growth rates followed by the stable
growth rate

High Growth Phase gh Stable growth phase gn

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 Valuation
• Discounted Cash Flow Models
– DDM
• Two Stage DDM
– The value of the stock is given by:

Present value of high growth phase + Present value of Terminal Value.

= DPS0 * (1+gh) *(1-((1+gh)/(1+gn))^n)/ (r- gh) [ Growth Phase]

+
DPS0 *(1+gh)^n *(1+gn)/ ((r-gn)*(1+r)^n)
[PV of terminal value]

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 Valuation
• Discounted Cash Flow Models
– DDM
• Two Stage DDM
– Limitations
» In this model, it is assumed that the high growth phase will fall to a stable phase
abruptly.
» Also, in the stable growth phase, the payout is expected to go up significantly.
» Moreover, other parameters like Beta, RoA, etc. are expected to be inline with the
stable growth phase.
» It is difficult to estimate the length of the high growth phase and the value of the
high growth itself.
» The terminal value contributes a large portion of price and it is sensitive to
assumptions of the stable growth rate.
– Best Uses: In the pharmaceucitcal company whose patent is about the lapse in the nth
year.
• Example

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 Valuation
• Discounted Cash Flow Models
– DDM
• Three Stage DDM
– Value of the stock price =
high growth phase + Transition Phase + Terminal Value

12%

10%

8%

6%
growth %
4%

2%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14

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 Valuation
• Discounted Cash Flow Models
– DDM
• Three Stage DDM

gh

gn

High Stable Growth Declining Infinite Stable

Growth Growth

High Payout Ratio

Increasing Payout
Low Payout Ratio
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 Valuation
• Discounted Cash Flow Models
– DDM
• Three Stage DDM
• Example

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 Valuation
• Discounted Cash Flow Models
– Free Cash Flow to Equity (FCFE)
• Net Income + Deprecation – Capital Spending - ∆
Working Capital – Principal Payments + New Debt
Issues
• For levered firm with optimal debt ratio,
Net Income + (1- δ) * (Capital Spending – Deprecation) –
(1- δ ) * ∆ Working Capital

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 Valuation
• Discounted Cash Flow Models
– Free Cash Flow to Equity (FCFE)
• Why dividends different from FCFE?

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 Valuation
• Discounted Cash Flow Models
– Free Cash Flow to Firm (FCFE)

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 Valuation
• Relative Valuation
– Price to Earnings Multiple
• It is widely used parameter for valuation because:
– It is intuitively appealing statistic that relates the price paid to
current earnings.
– It is simple to calculate for most of the stocks and is widely
available, making comparison across sectors simple
– It is proxy for a number of other characteristics of the firm,
including risk and growth
– One reason why mostly P/E ratio is used is that it avoids many
other assumptions that need to be done for the DCF
valuations.

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 Valuation
• Relative Valuation
– Price to Earnings Multiple
• Estimating P/E ratio from the fundamentals
P0 = DPS1/ (r-g)
Replace DPS1 by EPS0 * (1+g) * Payout Ratio
So,
P0 = EPS0 * Payout Ratio * (1+g) /( r-g)

P0/EPS0 = Payout Ratio * (1+g)/ (r-g)

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 Valuation
• Relative Valuation
– Price to Earnings Multiple
• Determinants of P/E Ratio
– Payout Ratio
– Growth rate
– Discount rate
– Riskiness of the firm (Beta)

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 Valuation
• Relative Valuation
– Price to Earnings Multiple
• Investment strategies that relate P/E ratios with
expected growth rate
– P/E to growth ratio is used to measure the relative value, with
lower value compared to peers is associated with the
undervaluation.
– There is no reason why a firm with lower P/E ratio with higher
expected growth is under valued. Lower P/E multiple could be
indicator of higher risk or higher interest rates.

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 Valuation
• Relative Valuation
– Price to Earnings Multiple
• Problems with P/E Ratio
– P/E ratios are not useful when earnings are negative
– P/E ratios also change dramatically with the volatility of the
earnings.

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 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Advantages of using Book Value
• Fundamental Determinant:
P0 = DPS1/ (r-g)
Replace DPS1 by EPS0 * (1+g) * Payout Ratio
So,
P0 = EPS0 * Payout Ratio * (1+g) /( r-g)
Now, EPS0 can be replaced by RoE *BV0

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Hence,
P0 = RoE * BV0 * Payout Ratio * (1+g)/ (r-g)
P0/ BV0 = RoE * Payout Ratio / (r-g)…. Assuming RoE is
based on expected earnings
Now, RoE * Payout = RoE – g
Hence,
P0/ BV0 = (RoE- g)/ (r-g)
This implies if RoE exceeds the required rate of return (r), the
price will exceed the book value and vice-a-versa.

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Equation for a high growth firm

RoE [ Payouth* (1+gh) *(1-((1+gh)/(1+gn))^n)/ (r- gh)

+ Payout n *(1+gh)^n *(1+gn)/ ((r-gn)*(1+r)^n) ]

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Determinants of P/ Bv
– RoE
– Payout ratio during high growth phase and during stable
growth phase
– Riskiness of the business (Beta)
– Expected growth rates in the firm

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Relationship with RoE
– RoE impacts the P/ Bv in two ways
» Directly (it being the numerator the ratio)
» Indirectly (it affecting the growth of the company
indirectly)
– Example
– When RoE = Required rate of return, r, the price is equal to
Book Value.

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Looking for undervalued securities
– Generally, P/ Bv is positively related to the RoE
– The point of interest could be the securities having a. higher
RoE and lower P/ Bv b. lower RoEs and higher P/ Bv
P/ Bv

RoE- r

CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Now, let’s look at the determinants of RoE
– To the extent that there is correlation between current RoE and
future RoE, it is fair to use the historical data. However, when the
competitive environment is changing, focusing on current RoE
could be dangerous and can lead to significant errors in valuation.
– The difference between the RoE and required rate of returns is
the measure of the firm’s capacity to earn supernormal profits in
the business it operates.
– One of the frameworks that can be used to analyze the degree of
such supernormal profits can be given by Porter’s Five Force
Model.

CONSCI
Porter’s 5 force Model Supplier Power

Threat of Entry
Industry
• Economies of Scale Threat of
Competitiveness
• Cost Advantage • Concentration Substitutes
• Capital Requirement • Product differentiation • Buyer’s
•Product Differentiation • Excess cpacity propensity to
• Access to distribution •Ratio of fixed to variable substitute
channels costs • Relative price
• Govt. & legal barriers • Demand growth performance of
•Retaliation by • Cyclical Fluctuations substitute
• Exit barriers
established producers

Buyer Power
Price Sensitivity Bargaining Power
• cost of purchase - Switching costs
relative to total costs - Buyer’s infon
• Profitability of buyers - ability to
• Importance of product backward
To quality of the buyer’s integration
product
CONSCI
 Valuation
• Relative Valuation
– Price to Book Value Multiple
• Limitations
– Book values are affected by accounting practices (like in
earnings)
– Book value may not carry much meaning for services firm that
does not have significant assets
– A firm having sustained string of negative profits can lead to
negative P/ Bv ratio

86 CONSCI Empowering People Transforming Businesses

 Valuation
• Relative Valuation
– Price to Sales Multiple
• Advantage of Price to sales ratio
– While P/ E and P/ Bv ratio can become negative, we can still
have P/ Sales ratio of the most troubled firm
– Sales are least influenced by the accounting practices and is
relatively difficult to manipulate
– P/ Sales ratios are less volatile compared to P/E and hence are
more reliable. For e.g. cyclical firm.
– P/ Sales ratio provides a convenient handle for examining the
effects of changes in pricing policy and other corporate
strategic decisions.

CONSCI
 • Relative Valuation
– Price to Sales Multiple
• Disadvantage of Price to sales ratio

88 CONSCI Empowering People Transforming Businesses