Chapter 10 of 15

Valuation principles

Worth 12 marks of 100Book pages 198 to 217About 75 minutes

Price is what you pay; value is what you get. Estimate value from cash flows, or compare with similar companies.

Chapter mapThirteen parts. 10.5 (DCF) and 10.7 to 10.8 (multiples) carry the numericals. Tap to jump.

10.1 to 10.3Price, value, sourcesWhy value, earnings and assets 10.4Three approachesCost, intrinsic, relative 10.5Discounted cash flowDDM, FCFE, FCFF, CAPM, WACC 10.6 and 10.7Earnings multiplesDividend yield, P/E, PEG, EV/EBITDA, EV/Sales 10.8Asset multiplesP/B, EV/capital employed, NAV, others 10.9 to 10.13Putting it togetherTrading versus transaction multiples, SOTP, new age, cautions

10.1

Price is not value

Two quotes from the bookSeth Klarman: "In capital markets, price is set by the most panicked seller; value, which is determined by cash flows and assets, is not." Warren Buffett: "Price is what you pay and Value is what you get."

Price comes from the stock market and is known to all. Value is the valuer's own estimate at a point in time. No formula gives a precise number, because the inputs are uncertain. At best, value is an educated estimate. That is why valuation is called both an art and a science: it needs knowledge, experience and professional judgement.

10.2 Why value a business?

Buying a business as an investment

Selling a business as an investment

Mergers and acquisitions

Owners' general sense of what it is worth

Fair treatment of stakeholders in an equity swap

Accounting, tax, regulatory and legal needs

Whatever the reason, the purpose is to relate price to value: is it fairly priced, over-priced or under-priced? Because of the uncertainty, valuers usually present several scenarios showing how value changes with the main inputs.

10.3 Where value comes from: earnings and assets

Buffett, quoted in the book: "There are only two sources of value in a business: Earnings and Assets." Every asset produces periodic earnings plus a final inflow when it is sold.

Two streams of cash from every asset

Asset	Periodic earnings	One-time inflow
Bond	Coupons	Redemption or sale
Equity share	Dividends	Sale of the share
Real estate	Rent	Appreciated value on sale
Business	Earnings (cash flows)	Sale of tangible and intangible assets, if earnings fall short

Lenders think the same way. A bank first checks whether the borrower's cash flows can repay the loan. The collateral is only a fallback if those estimates prove wrong. As the book warns, assets may be worth much less than their balance sheet value, but liabilities must be paid in full.

10.4

Three approaches to valuation

Cost, intrinsic, relativeThe book focuses on the last two

Cost based

Value = cost to create the asset. Suits only a buyer choosing between buying and making. Most stock market investors cannot build the company themselves, so it is generally not suitable for financial investors. Strategic, long-term investors may use it. Often needs technical assessment by engineers.

Cash flow based (intrinsic)

Value = what an investor would pay for the asset's cash flows, discounted at the return they expect.

Risk neutral: cash flows adjusted for probability, discounted at the risk-free rate. Used for insurance companies (embedded value and appraisal value).
Real world: most likely cash flows, discounted at risk-free rate plus a risk premium.

Selling price based (relative)

Value from the prices of similar assets, using ratios such as P/E, P/B, EV/EBITDA.

10.5

Discounted cash flow (DCF)

Start with a bond. It pays 9% a year and repays its face value of Rs 1,00,000 after 10 years. Investors also expect 9% for this maturity and credit quality. Its value today is the present value of all its cash flows at 9%, which comes to exactly the face value. If investors expect more than 9%, the value is below face value; if less, above.

Every asset is valued the same way. For equity, dividends replace coupons and the sale price replaces redemption. The difference: a bond's cash flows and timing are known; equity's are uncertain. So DCF valuations of businesses carry significant judgement error and can be very sensitive to some inputs.

DCF works best when three things are knownThen the rest is simple present-value mathematics

1. Future cash flows

The stream of free cash flows (inflows over outflows)

2. Their timing

When each cash flow arrives

3. Discount rate

The return investors expect

Present value

What an investor would pay today

Analysts' DCF values differ mainly because they estimate the cash flows and the discount rate differently.

Three DCF models

Model	What is discounted	Discount rate	Best for
Dividend discount model (DDM)	Expected future dividends	Cost of equity	Companies paying regular, substantial dividends: mature companies in defensive industries
Free cash flow to equity (FCFE)	Cash flow available to equity shareholders, instead of actual dividends	Cost of equity	Companies that pay little or no dividend, and companies in high growth. Book example: Alphabet (Google's parent) has never paid a dividend
Free cash flow to firm (FCFF)	Cash flow before any payments to any source of capital	WACC	When the company has no objective debt policy, so future borrowing cannot be estimated for FCFE

Gordon growth model

Also called the perpetual growth model. It values a company whose dividend is expected to grow forever at a constant rate.

P = D1 ÷ (k − g)

D1 = dividend expected at the end of the year. k = cost of equity. g = constant growth rate, which must be lower than k.

Use next year's dividend (D1), not the one just paid. If the last dividend was Rs 4 and growth is 5%, D1 = 4 × 1.05 = Rs 4.20.

Free cash flow formulas (as given in the book)

FCFE and FCFFFigures come from the cash flow statement

FCFEOperating cash flow
− Capital expenditure
− Interest payments
± Net borrowings (repayments)
= Free cash flow to equity
FCFF, directOperating cash flow
− Capital expenditure
− Tax benefit on interest payments
= Free cash flow to the firm
FCFF, indirectEBIT × (1 − tax rate)
+ Depreciation and non-cash charges
− Increase (+ decrease) in non-cash working capital
− Capital expenditure (+ sale of assets)

Non-cash charges added back include amortisation and loss on sale of assets. A gain on sale of assets is deducted. (In the book the direct FCFF list ends with the label "Free cash flow to equity"; the section is about FCFF.)

Two-stage valuation for high-growth companies

A fast-growing company's growth may be unsustainable and even above its cost of capital, so a single constant growth rate does not fit. Value it in two stages:

Value = high-growth years + terminal value

Stage 1

Estimate how long high growth lasts. Forecast each year's free cash flow and discount it

Stage 2: terminal value

Gordon model on the cash flow after high growth, or an exit value: EBITDA (or EBIT) at the end × EV/EBITDA (or EV/EBIT) of comparable firms

Discount the terminal value

It is a future amount, so bring it back to present value too

Add them up

Value of equity (FCFE) or of the firm (FCFF)

Capping the perpetual growth rateThe perpetual growth rate is often capped at the long-term nominal GDP growth rate of the company's markets, because no business can outgrow the economy forever. Analysts may use a lower rate. A rough forecast can extrapolate past growth; analysts refine it using the share of earnings ploughed back and the expected return on equity.

From firm value to equity value (FCFF)

Value of equity = Firm value − minority interest − preferred share capital − interest-bearing debt

To get enterprise value, the book deducts surplus cash, cash equivalents and short-term investments not needed for current operations from the firm value.

The discount rate

It should reflect the risk in the cash flows. FCFF is discounted at WACC (debt and equity). FCFE is discounted at the cost of equity. Cost of debt is usually the prevailing interest rate for borrowers of comparable credit quality. Cost of equity is the return the company's shareholders require.

CAPM and WACCThe book's formulas

Cost of equity: CAPM

Ke = Rf + β × (Rm − Rf)

Rf: risk-free rate
Rm − Rf: market risk premium (MRP)
β (beta): sensitivity of the stock's return to the market's; a proxy for business and financial risk
β × (Rm − Rf): equity risk premium paid over the risk-free rate

Weighted average cost of capital

WACC = Ke × We + Kd × (1 − Tax) × Wd

We = Equity ÷ (Equity + Debt)
Wd = Debt ÷ (Equity + Debt)
Kd: cost of debt, taken after tax because interest saves tax

Try it: CAPM, WACC and GordonChange any number. All rates are % a year.

Rates

Risk-free rate

Market return

Beta

Cost of debt

Capital mix and dividend

Debt weight %

Tax rate %

Next dividend D1 (Rs)

Dividend growth g

market risk premium

cost of equity (Ke)

WACC

Gordon value per share

DCF gives wrong answers if the cash flows and the discount rate are not estimated with enough rigour. A small change in the discount rate or growth rate can move the value a lot.

10.6 and 10.7

Relative valuation: earnings multiples

DCF is complicated and rests on many assumptions. Relative valuation compares what we pay (price) with what we get (earnings or assets). It does not give an absolute value, but shows whether something looks cheap or expensive, which supports a buy, sell or hold call.

10.7.1 Dividend yield and price to dividend

Dividend yield = Dividend per share ÷ Current price

The book's example: a company has paid Rs 5 or more in dividend every year for five years.

Same Rs 5 dividend, four pricesThe book's table

Price (Rs)	50	100	150	200
Dividend (Rs)	5	5	5	5
Dividend yield	10.00%	5.00%	3.33%	2.50%
Price / dividend	10	20	30	40

Price to dividend = what the market pays for one rupee of dividend.

Compare dividend yield with bond yields. The book: a 10% bond taxed at 30% leaves about 7% after tax; at Rs 50 the share's 10% dividend yield looks better, with potential upside too. At Rs 200, the 2.5% yield is clearly inferior.
When equity yields are generally above bond yields, equity is cheap; this is typical when markets are down. In bull markets, equity yields are well below bond yields.
A high dividend yield is not always a value pick: a high payout may mean few avenues to grow, limiting capital gains. Check it against company fundamentals, which the book calls companion variables.

10.7.2 Earnings yield and P/E

Earnings yield = EPS ÷ Current price | P/E = Current price ÷ EPS (its reciprocal)

Analysts move to earnings yield when dividend yields are very low.
P/E is the money needed to buy one unit of profit. It uses historical EPS, or forecast EPS for forward P/E.
All else equal, a P/E above peers and the market looks expensive; below looks undervalued.
But companies with higher growth or lower risk deserve a premium; lower growth or higher risk, a discount.
Earnings are for a period; price is at a point. Choose the EPS period with judgement: investors usually weigh future earnings more, and may use next year's if this year's is unusually high or low.

10.7.3 PEG ratio

PEG = (Price ÷ EPS) ÷ Growth rate

Coined by Peter Lynch. A high P/E can be justified by high growth, but high growth may not last. Lynch: PEG below 1 may be treated as undervalued. Use rules of thumb with care; comparing PEGs across competitors is more useful.

P/E says A, PEG says BThe book's example: both have EPS of Rs 10

	A Ltd	B Ltd
Price	Rs 120	Rs 140
P/E	12x	14x
Expected growth	10% a year	15% a year
PEG	12 ÷ 10 = 1.2x	14 ÷ 15 = 0.93x
Verdict	Cheaper on P/E	Better value once growth is counted

10.7.4 EV to EBIT(DA)

EPS, and so P/E and PEG, depend on the company's capital structure (equity has the residual claim). A retail investor cannot change that; a controlling shareholder can. So from an acquirer's view, or for a takeover target, use ratios neutral to capital structure: EV/EBIT or EV/EBITDA (see 3.1.7 for EV).

EV/EBITDA

Preferred for capital-intensive industries, where historical asset costs and depreciation choices distort EBIT.

EV/EBIT

Preferred for other industries.

Lower ratios look more attractive, all else equal; higher growth or lower risk earns a premium.

10.7.5 EV to sales

P/E, EV/EBITDA and EV/EBIT cannot be used when profit is negative, and are too high to mean much when a company has only just broken even. Sales are never negative, so EV/Sales works. But only if the company is likely to turn and stay profitable. If no turnaround is likely, its "going concern" status is doubtful and it should be valued at liquidation value.

10.8

Relative valuation: asset multiples

Here assets replace earnings. Two ratios from earlier chapters: ROE = net profit ÷ net worth (return on the book value of equity); ROCE = EBIT ÷ capital employed (debt + net worth).

10.8.1 Price to book value

P/B = Market cap ÷ Book value of equity = Price per share ÷ Book value per share

How much an investor pays for ownership of one unit of the company's net assets.

Financial companies

Preferred here. Their assets are mostly monetary, so book value is close to fair value.

Capital-intensive firms

Historical cost accounting means book values often do not reflect fair value.

Services and technology

Their key assets, people and self-generated intellectual property, are not on the balance sheet.

Because accounting is conservative, book value is often used for a conservative value of equity. Lower P/B looks more attractive, all else equal, but a higher ROE deserves a premium.

The book's P/B exampleRs lakh, 50 lakh shares of Rs 10 each

	AFB Finance	LKH Finance
Share capital	500	500
Share premium	3,200	2,100
Reserves and surplus	6,200	5,400
Total equity	9,900	8,000
Book value per share	9,900 ÷ 50 = Rs 198	8,000 ÷ 50 = Rs 160
Market price	Rs 200	Rs 175
P/B	1.01	1.09

On P/B alone, AFB Finance is less expensive, even though its share price is higher.

Compare a company's multiple with the industry, not just one peer. In a fragmented industry, a few outliers can pull the mean up while most firms sit near the median. Check both before deciding.

10.8.2 EV to capital employed

EV / Capital employed = EV ÷ (Total equity + Total debt)

Used together with ROCE, it shows the return an investor actually earns on the price paid.

The book's EV to capital employed example

Capital employed

Net worth 1,00,000 + debt 1,00,000 = 2,00,000

EV

Market cap 5,00,000 + debt 1,00,000 − cash 0 = 6,00,000

EV / CE = 3

ROCE of 45% on 2,00,000 is only 15% on 6,00,000

Want 20%?

Pay at most 45 ÷ 20 = 2.25x capital employed, that is EV of Rs 4,50,000

10.8.3 Net asset value (NAV)

NAV = market value of assets minus liabilities. Unlike book value, it uses market values. It can be stated in total or per share. Used for very asset-heavy businesses such as real estate, shipping and aviation.

10.8.4 Other metrics

Industry-specific multiples

Life insurance

Price / Embedded value

Embedded value: present value of expected net future cash flows (probability-adjusted) from policies now in force.

NBFCs

Price / Adjusted book value

Adjusted book value: fair value of assets minus fair value of liabilities. Includes off-balance sheet items.

Start-ups, special situations

EV / Capacity

Operating metrics instead of financial ones: a closed steel plant by its production capacity; an e-commerce start-up by users, transactions or transaction value.

10.9

Trading and transaction multiples

Buying a flat: you check what similar flats in the locality sold for, and that becomes your starting point for negotiation. That is relative valuation. Quick and intuitive, but it reflects the current market mood, which may be too optimistic or too pessimistic.

So use the maximum, minimum and average of the multiples, look at each company's own history over several years, and compare across peers and the industry.

Trading multiples

From prices in the stock market.

Transaction multiples

From similar deals completed recently. More relevant and more authentic: someone actually agreed to buy at that value.

10.10 Sum of the parts (SOTP)

Conglomerates such as ITC and L&T run many businesses under one umbrella. Value each business separately, as an independent business, using the methods above, then add them up. The book calls this sum-of-the-parts (SOTP or SOP) valuation.

10.11 New-age businesses

Valuations of companies like WhatsApp, Zomato, LinkedIn and Facebook are hard to explain with numbers. Such deals use new measures: eyeballs, page views, footfall, ARPU, number of users. As Buffett would say, these must eventually become profits for owners. Without that, valuations last only as long as the story and the next buyer, and can fall like a pack of cards, as in the dot-com boom of 2000 to 2001.

10.12 Is valuation objective?

It may look objective, but it is very subjective: the inputs have no generally accepted standards. It is also not timeless; it can change dramatically when the business changes. Complicated models do not make a value precise. They only give a false impression of preciseness.

10.13 Nine things to keep in mind

High earning power: book value matters less. Low earning power: book value matters a lot.
A share is part ownership, so to value a share, value the whole business.
For a private owner, the true value of the firm is EV, not market cap.
P/E of a leveraged firm can deceive: look at its debt.
Use consolidated numbers, not just standalone.
Focus on ROE, not EPS: EPS ignores retained earnings.
Leverage improves ROE, but excessive leverage is risky.
ROCE reflects the true return on capital; ROE can be inflated by high leverage.
ROCE and ROE should be close. A wide gap should trigger investigation.

All exam traps in this chapter

Price is known to all; value is an estimate. Valuation is an art and a science.
Buffett: only two sources of value, earnings and assets.
Lenders look at cash flows first; collateral is a fallback.
Cost-based valuation suits buy-versus-make decisions; generally not for financial investors.
Risk-neutral valuation discounts at the risk-free rate; used for insurers. Real-world adds a risk premium.
A bond whose coupon equals the required return is worth its face value.
DCF needs cash flows, timing and discount rate.
DDM suits mature dividend payers in defensive industries. FCFE suits low-dividend and high-growth firms. FCFF suits firms without an objective debt policy.
Gordon: P = D1 ÷ (k − g). D1 is next year's dividend; g must be below k.
FCFF is discounted at WACC; FCFE and dividends at cost of equity.
Terminal value: perpetual growth capped at long-term nominal GDP growth, or an exit multiple. Discount it to present value.
Equity value = firm value − minority interest − preferred capital − interest-bearing debt.
CAPM: Ke = Rf + β(Rm − Rf). Rm − Rf is the market risk premium.
WACC uses after-tax cost of debt: Kd × (1 − tax).
Dividend yield = DPS ÷ price. Price/dividend is its reciprocal.
Earnings yield = EPS ÷ price; P/E is its reciprocal.
PEG = P/E ÷ growth; coined by Peter Lynch; below 1 may mean undervalued.
EV/EBITDA and EV/EBIT are neutral to capital structure; suit acquirers. EV/EBITDA for capital-intensive industries.
EV/Sales for loss-making or just-profitable firms likely to turn profitable; otherwise liquidation value.
P/B is preferred for financial companies; poor for services and technology firms.
NAV uses market value of assets; used for real estate, shipping, aviation.
P/Embedded value: life insurers. P/Adjusted book value: NBFCs. EV/Capacity: start-ups and special situations.
Transaction multiples are more relevant than trading multiples.
SOTP: value each business separately and add up (ITC, L&T).
Focus on ROE, not EPS. ROCE reflects true return on capital; a wide gap with ROE needs investigation.

For the group discussion

Pick a listed company. What would you need to know to value it by DCF? Which input are you least sure of?
Why might a bank trade on P/B and a software company on P/E? What could go wrong with each?
A start-up is valued on users, not profit. When is that reasonable, and when is it a story?
Two companies have the same P/E. One has no debt, the other is heavily borrowed. Which is cheaper?
Try the calculator: how much does the Gordon value change if growth moves from 8% to 9%? What does that tell you about DCF?