Unit 4

Relative valuation

Prepared By
Sushant Bathla 1
Steps in developing a Forecasted model
1. Estimate revenue growth and future expected
revenue (using market growth plus market share,
trend growth rate, or growth relative to GDP
growth)
2. Estimate COGS (based on a percentage of sales, or
on a more detailed method based on business
strategy or competitive environment).
3. Estimate SG&A (as either fixed, growing with
revenue, or using some other estimation
technique).
Prepared By sushant bathla 2
Steps in developing a Forecasted model
4. Estimate financing costs (using interest rates, debt
levels, and the effects of any large anticipated
increases or decreases in capital expenditures
or anticipated changes in financial structure)
5. Estimate income tax expense and cash taxes
6. Model the balance sheet based on items that
flow from the income statement [working capital
accounts (i.e., accounts receivable, accounts payable,
and inventory)].
Prepared By sushant bathla 3
Steps in developing a Forecasted model
7. Use depreciation and capital expenditures (for
maintenance and for growth) to estimate capital
expenditures and net PP&E for the balance sheet.
8. Use the completed pro forma income statement and
balance sheet to construct a pro forma cash flow
statement.
An analyst must always decide when additional or more
complex analysis is warranted and when additional
complexity in the estimation method provides real benefits
in terms of improved forecasts and value estimates.

Prepared By sushant bathla 4

 Operating cash flow computation

Cash collections from customers Add

Cash paid to supplier Subtract

Cash paid for operating expenses Subtract

Cash paid for interest Subtract

Cash paid for taxes Subtract

Operating cash flow $

Prepared By sushant bathla 5

 Operating cash flow computation
Indirect Methods Format
Net income $

Adjustments to Non cash charges(Example Add

dep and amortization, Deferred Income tax)
Decrease in accounts receivable Add

Increase in inventory Subtract

Decrease in prepaid expenses Add

Increase in account Payable Add

Increase in accrued Liability Add

Operating Cash Flow $

Prepared By sushant bathla 6

Adjustments to Net Income Using the Indirect
Method

Net Income
 Depreciation expense of tangible assets
 Amortisation expense of intangible assets
 Depletion expense of natural resources
Non cash Items  Amortisation of bond discount

 Increase in current operating liabilities (e.g.,

Add accounts payable and accrued expense liabilities)
 Decrease in current operating assets (e.g.,
accounts receivable, inventory, and prepaid
expenses)
Non cash Items
 Gain on sale of assets
 Gain on retirement of debt
CFO  amortisation of bond premium

Prepared By sushant bathla 7

 Computing FCFF from Net Income
 FCFF is the cash flow available to the company’s suppliers of capital after all
operating expenses (including taxes) have been paid and operating
investments have been made.
 The company’s suppliers of capital include bondholders and common
shareholders
Net
Net income
income for
for Non
Non cash
cash
FCFF
FCFF = common
common shareholder
shareholder + charges
charges

Interest×(1-tax
Interest×(1-tax rate) Investment
Investment in
in working
working
+ rate) - capital
capital

- Investment
Investment in
in Fixed
Fixed
capital
capital

Prepared By sushant bathla 8

Computing FCFF from the Statement of Cash
Flows
 Analysts frequently use cash flow from operations, taken from the
statement of cash flows, as a starting point to compute free cash flow
because CFO incorporates adjustments for noncash expenses (such as
depreciation and amortization) as well as for net investments in working
capital

= Cash
Cash flow
flow from
from +
FCFF
FCFF Interest×(1-tax
Interest×(1-tax rate)
rate)
operation
operation

- Investment
Investment in
in Fixed
Fixed
capital
capital

Prepared By sushant bathla 9

 Free Cash Flow
FCFF FCFE

= =
Cash Flow available to Cash Flow available to

+ +
Common Stock Common Stock

+
Debt Holder

+
Preferred shareholder
Prepared By sushant bathla 10
 FCFF and FCFE from EBIT
FCFF = EBIT×(1-Tax rate) + Non Cash charges
FCFF EBIT×(1-Tax rate) Non Cash charges

- Investment in Fixed Investment in Working

- Investment
Investment in Fixed in Working
capital capital
capital capital

Net Income+ Interest × (1- Tax rate)= EBIT×(1- tax rate)

= +
FCFE FCFF Net Borrowing
FCFE FCFF Net Borrowing

- Interest×(1-tax rate)
Interest×(1-tax rate)

Prepared By sushant bathla 11

 FCFF and FCFE from EBITDA
FCFF = EBITDA×(1-Tax rate) + Depreciation×(Tax
rate)

- Investment in Fixed - Investment in Working

capital capital

Net Income+ Interest × (1- Tax rate)= EBIT×(1- tax rate)

= +
FCFE FCFF Net Borrowing

- Interest×(1-tax rate)

Prepared By sushant bathla 12

 Sustainable Growth Rate
 It estimate the stable growth rate in a Gordon growth model
valuation, or the mature growth rate in a multistage DDM in
which the Gordon growth formula is used to find the terminal
value of the stock

g = b × ROE   Formula

Prepared By sushant bathla 13

 Dividend Growth Rate, Retention Rate, and ROE Analysis

•Sustainable
  growth rate will be
g=

Retention ratio (R) Profit Margin(P) Asset Turnover(A) Financial leverage(T)

 This expansion of the sustainable growth expression has been called
the PRAT model

Prepared By sushant bathla 14

 COST OF CAPITAL
WACC = wdrd(1 – t) + wprp + were

Example: ABC Corporation has the following capital structure: 30 percent debt, 10 percent
preferred stock, and 60 percent equity. Its before-tax cost of debt is 8 percent, its cost of
preferred stock is 10 percent, and its cost of equity is 15 percent. If the company’s marginal
tax rate is 40 percent, what is ABC’s weighted average cost of capital?
Always take
marginal tax rate
Solution not average tax
rate
The weighted average cost of capital is
WACC = (0.3)(0.08)(1 – 0.40) + (0.1)(0.1) + (0.6)(0.15)
 = 11.44 %
 Cost of Equity
Cost of Equity

Capital Asset Pricing Dividend Discount Bond Yield plus Risk

Model Approach Model Approach Premium Approach

 
 E(Ri)=RF+βi[E(RM)−RF] r=+g re = rd + Risk premium
 Capital Asset Pricing Model Approach
A. Capital Asset Pricing Model Approach: expected return on a
stock, E(Ri), is the sum of the risk-free rate of interest, RF, and
a premium for bearing the stock’s market risk, βi(RM − RF)

E(Ri)=RF+βi[E(RM)−RF]
βi = the return sensitivity of stock i to changes in the market
return
E(RM) = the expected return on the market
E(RM) − RF = the expected market risk premium
Capital Asset Pricing Model Approach  
 A risk-free asset is defined as an asset that has no default risk
 A common proxy for the risk-free rate is the yield on a default-
free government debt instrument
Example: Risk-free rate is 5 percent, equity risk premium is 7
percent, and Company’s equity beta is 1.5. What is Company’s
cost of equity using the CAPM approach?
Solution:
Cost of common stock = 5 percent + 1.5(7 percent) = 15.5 %
Capital Asset Pricing Model Approach   
 E(RM − RF), is the premium that investors demand for investing
in a market portfolio relative to the risk-free rate
Equity risk premium:The expected return on equities minus the
risk-free rate; the premium that investors demand for investing
in equities
 Multifactor model that incorporates factors that may be
other sources of priced risk (risk for which investors demand
compensation for bearing), including macroeconomic factors
and company-specific factors
E(Ri)=RF+βi1(Factor risk premium)1+βi2(Factor risk premium)2+
…+βij(Factor risk premium)j
 Ways to estimate the equity risk premium 

i. Historical equity risk premium approach: An estimate of a

country’s equity risk premium that is based upon the
historical averages of the risk-free rate and the rate of return
on the market portfolio
 For example, an analyst might use the historical returns to the
TOPIX Index to estimate the risk premium for Japanese
equities
Ways to estimate the equity risk premium 

• Survey
II.   approach: An estimate of the equity risk premium that
is based upon estimates provided by a panel of finance experts

Dividend discount model based approach:

Gordon Growth model 
P=
Ways to estimate the equity risk premium 

•   for the required rate of return on the market as

solve
 re=+g

Therefore, the expected return on the market is the sum of the

dividend yield and the growth rate in dividends.
Ways to estimate the equity risk premium 

•   for the required rate of return on the market as

solve
 re=+g

Therefore, the expected return on the market is the sum of the

dividend yield and the growth rate in dividends.
 Bond Yield plus Risk Premium Approach
 An estimate of the cost of common equity that is produced by
summing the before-tax cost of debt and a risk premium that
captures the additional yield on a company’s stock relative to
its bonds
re = rd + Risk premium
 this risk premium is forward looking, representing the
additional risk associated with the stock of the company as
compared with the bonds of the same company
 The Method of Comparables

PRESENT VALUE MODELS

Method of comparables: An approach to valuation that involves using

a price multiple to evaluate whether an asset is relatively fairly valued,
relatively undervalued, or relatively overvalued when compared to a
benchmark value of the multiple
 For example, a P/E of 20 means that it takes 20 units of currency
(for example, €20) to buy one unit of earnings
 The economic rationale underlying the method of comparables is
the law of one price
Law of one price: A principle that states that if two investments have
the same or equivalent future cash flows regardless of what will
happen in the future, then these two investments should have the
same current price

Prepared By sushant bathla 25

 PRICE MULTIPLES

PRESENT VALUE MODELS

Rationales support the use of P/E multiples in valuation:

1. Earning power is a chief driver of investment value, and EPS, the
denominator in the P/E ratio, is perhaps the chief focus of security
analysts
2. The P/E ratio is widely recognized and used by investors
3. Differences in stocks’ P/Es may be related to differences in long-
run average returns on investments in those stocks, according to
empirical research

Prepared By sushant bathla 26

 PRICE MULTIPLES

PRESENT VALUE MODELS

 Potential drawbacks to using P/E derive:

1. EPS can be zero, negative, or insignificantly small relative to price, and P/E does
not make economic sense with a zero, negative, or insignificantly small
denominator
2. The ongoing or recurring components of earnings that are most important in
determining intrinsic value can be practically difficult to distinguish 
3. In making choices and estimates, managers may distort EPS as an accurate
reflection of economic performance

27
 PRICE MULTIPLES

PRESENT VALUE MODELS

The analyst must take care in determining the EPS to be used in the
denominator. The analyst must consider the following:
I. Potential dilution of EPS
II. Transitory, nonrecurring components of earnings that are
company specific
III. Transitory components of earnings related to cyclicality (business
or industry cyclicality)
IV. Differences in accounting methods 

 Companies are themselves required to present both basic EPS and

diluted EPS

Prepared By sushant bathla 28

 Analyst Adjustments for Nonrecurring Items

PRESENT VALUE MODELS

 The analyst’s focus is on estimating underlying earnings (other names

for this concept include persistent earnings, continuing earnings,
and core earnings) earnings that exclude nonrecurring items
 An increase in underlying earnings reflects an increase in earnings that
the analyst expects to persist into the future
 Nonrecurring items (for example, gains and losses from the sale of
assets, asset write-downs, goodwill impairment, provisions for
future losses, and changes in accounting estimates) often appear in
the income from continuing operations portion of a business’s income
statement so in this adjustment is required. Cannot rely on income
statement classifications alone

Prepared By sushant bathla 29

 Valuation Based on Comparables

PRESENT VALUE MODELS

Method of comparables involves the following steps:

1. Select and calculate the price multiple that will be used in the
comparison
2. Select the comparison asset or assets and calculate the value of the
multiple for the comparison asset(s). For a group of comparison assets,
calculate a median or mean value of the multiple for the
assets(benchmark value of Multiple)
3. Use the benchmark value of the multiple, possibly subjectively adjusted
for differences in fundamentals, to estimate the value of a
company’s stock
4. Assess whether differences between the estimated value of the
company’s stock and the current price of the company’s stock are
explained by differences in the fundamental determinants of the
price multiple
Prepared By sushant bathla 30
 Valuation Based on Comparables

PRESENT VALUE MODELS

Benchmark value of the P/E derived from these assets include the following:
1. The average or median value of the P/E for the company’s peer group of
companies within an industry
2. The average or median value of the P/E for the company’s industry or
sector
3. The P/E for a representative equity index
4. An average past value of the P/E for the stock

Peer-Company Multiples: Companies operating in the same industry as the

subject company (i.e., its peer group) are frequently used as comparison
assets. This approach is consistent with the idea underlying the method of
comparables. The subject stock’s P/E is compared with the median or mean
P/E for the peer group to arrive at a relative valuation

Prepared By sushant bathla 31

 Price to Book Value
 The measure of value in the P/B’s denominator (book value per share) is a
stock or level variable coming from the balance sheet
Book value per share: Calculated by dividing the book value of shareholders’
equity by the number of shares of common stock outstanding
several rationales for the use of P/B
1. Book value is generally positive even when EPS is zero or negative
2. Book value per share is more stable than EPS
3. Book value per share has been viewed as appropriate for valuing
companies composed chiefly of liquid assets, such as finance,
investment, insurance, and banking institutions
4. used in the valuation of companies that are not expected to continue as
a going concern 
5. Differences in P/B may be related to differences in long-run average
returns, according to empirical research
Prepared By sushant bathla 32
 Price to Book Value
Drawbacks of P/B:
1. The value of skills and knowledge possessed by the workforce—is more
important than physical capital as an operating factor, but it is not
reflected as an asset on the balance sheet
2. P/B may be misleading as a valuation indicator when the levels of assets
used by the companies under examination differ significantly. For
example a firm that outsource its production will have fewer asset
3. Intangible assets that are generated internally (as opposed to being
acquired) are not shown as assets on a company’s balance sheet
4. Some assets and liabilities, such as some financial instruments, may be
reported at fair value as of the balance sheet date; other assets, such as
property, plant, and equipment, are generally reported at historical cost.
Book value per share often does not accurately reflect the value of
shareholders’ investments

Prepared By sushant bathla 33

 Price to Book Value
To make P/B more useful for making comparisons among different stocks.
Some adjustments are as follows:
1. Computing tangible book value per share involves subtracting reported
intangible assets on the balance sheet from common shareholders’
equity.  Exclusion may be appropriate, however, for goodwill from
acquisitions, particularly for comparative purposes. Goodwill represents
the excess of the purchase price of an acquisition beyond the fair value
of acquired tangible assets and specifically identifiable intangible assets
2. Certain adjustments may be appropriate for enhancing comparability.
For example, one company may use FIFO whereas a peer company uses
LIFO, which in an inflationary environment will generally understate
inventory values
3. the balance sheet should be adjusted for significant off-balance sheet
assets and liabilities

Prepared By sushant bathla 34

 Price to Sales
 Certain types of privately held companies, including investment management
companies and many types of companies in partnership form, have long been valued
by a multiple of annual revenues
Following rationales for using P/S:
• Sales are generally less subject to distortion or manipulation than are other
fundamentals, such as EPS or book value. In contrast, total sales, as the top line in the
income statement, is prior to any expenses.
• Sales are positive even when EPS is negative. Therefore, analysts can use P/S when EPS
is negative
• Because sales are generally more stable than EPS, which reflects operating and
financial leverage, P/S may be more meaningful than P/E when EPS is abnormally high
or low.
• P/S has been viewed as appropriate for valuing the stocks of mature, cyclical, and zero-
income companies
• Differences in P/S multiples may be related to differences in long-run average returns,
according to empirical research

Prepared By sushant bathla 35

 Price to Sales
Drawbacks of using P/S:
 A business may show high growth in sales even when it is not
operating profitably as judged by earnings
 In the P/S multiple, however, price is compared with sales, which is
a pre financing income measure—a logical mismatch. For this
reason, some experts use a ratio of enterprise value to sales
because enterprise value incorporates the value of debt
 P/S does not reflect differences in cost structures among different
companies.
 Revenue recognition practices have the potential to distort P/S.

Prepared By sushant bathla 36

 Price to Cash Flow
Following rationales for the use of price to cash flow:
• Cash flow is less subject to manipulation by management
than earnings.
• Because cash flow is generally more stable than earnings,
price to cash flow is generally more stable than P/E.
• Using price to cash flow rather than P/E addresses the issue
of differences in accounting conservatism between
companies (differences in the quality of earnings).
• Differences in price to cash flow may be related to differences
in long-run average returns, according to empirical research

Prepared By sushant bathla 37

 Price to Cash Flow
Drawbacks to the use of price to cash flow:
• When cash flow from operations is defined as EPS plus noncash charges, items
affecting actual cash flow from operations, such as noncash revenue and net
changes in working capital, are ignored
• Theory views free cash flow to equity (FCFE) rather than cash flow as the
appropriate variable for price-based valuation multiples. We can use P/FCFE
but FCFE does have the possible drawback of being more volatile than cash
flow for many businesses. FCFE is also more frequently negative than cash
flow.
• As analysts’ use of cash flow has increased over time, some companies have
increased their use of accounting methods that enhance cash flow measures.
Operating cash flow, for example, can be enhanced by securitizing accounts
receivable to speed up a company’s operating cash inflow or by outsourcing
the payment of accounts payable to slow down the company’s operating cash
outflow

38
 ENTERPRISE VALUE MULTIPLES
A valuation multiple that relates the total market value of all sources of a company’s
capital (net of cash) to a measure of fundamental value for the entire company (such
as a pre-interest earnings measure)
 EBITDA was introduced as an estimate of pre-interest, pretax operating cash flow.
Because EBITDA is a flow to both debt and equity, as noted, defining an EBITDA
multiple by using a measure of total company value in the numerator, such as EV
 enterprise value is total company value (the market value of debt, common equity,
and preferred equity) minus the value of cash and short-term investments
Analysts have offered the following rationales for using EV/EBITDA:
I. EV/EBITDA is usually more appropriate than P/E alone for comparing companies
with different financial leverage (debt)
II. By adding back depreciation and amortization, EBITDA controls for differences in
depreciation and amortization among businesses, in contrast to net income
III. EBITDA is frequently positive when EPS is negative

39
 Enterprise value multiple
Drawbacks to using EV/EBITDA include the following:
 EBITDA will overestimate cash flow from operations if working capital
is growing
 Free cash flow to the firm (FCFF), which directly reflects the amount
of the company’s required capital expenditures, has a stronger link to
valuation theory than does EBITDA

40
 Enterprise Value to Sales
 Enterprise value to sales is a major alternative to the price-to-
sales ratio
 The P/S multiple has the conceptual weakness that it fails to
recognize that for a debt-financed company, not all sales
belong to a company’s equity investors. Some of the proceeds
from the company’s sales will be used to pay interest and
principal to the providers of the company’s debt capital

41
 Monte Carlo simulation
• Monte Carlo simulation is a technique based on the repeated
generation of one or more risk factors that affect security values, in
order to generate a distribution of security values.
• For each of the risk factors, the analyst must specify the parameters of
the probability distribution that the risk factor is assumed to follow.
• A computer is then used to generate random values for each risk factor
based on its assumed probability distributions.
• Each set of randomly generated risk factors is used with a pricing
model to value the security.
• This procedure is repeated many times (100s, 1,000s, or 10,000s), and
the distribution of simulated asset values is used to draw inferences
about the expected (mean) value of the security and possibly the
variance of security values about the mean as well.

Prepared By sushant bathla 42

 Sensitivity analysis
• Sensitivity analysis is a financial model
that determines how target variables are
affected based on changes input
variables. This model is also referred to as
what-if or simulation analysis. It is a way
to predict the outcome of a decision given
a certain range of variables

Prepared By sushant bathla 43

 Scenario analysis
• Scenario analysis is a process of examining
and evaluating possible events or scenarios
that could take place in the future and
predicting the various feasible results or
possible outcomes. In financial modeling, the
process is typically used to estimate changes
in the value of a business or cash flow,
especially when there are potentially
favorable and unfavorable events that could
impact the company.
Prepared By sushant bathla 44
 Myths in valuation
Myth 1.: A good valuation provides a precise
estimate of value
Truth 1.1: There are no precise valuations.
Truth 1.2: The payoff to valuation is greatest
when valuation is least precise.

Prepared By sushant bathla 45

 Myths in valuation
Myth 2: . The more quantitative a model, the
better the valuation
Truth 2.1: One’s understanding of a valuation
model is inversely proportional to the number of
inputs required for the model.
Truth 2.2: Simpler valuation models do much
better than complex ones.

Prepared By sushant bathla 46

 Myths in valuation
• Myth #3: A well-researched and well-done
valuation is timeless
Truth just because something has been true in
the past does not mean that it will continue being
true in the future.
The value of an asset can and will fluctuate over
time, and it is therefore important for the analyst
to periodically update their models

Prepared By sushant bathla 47