bav 2014 pgp indore visit i.pptx

8/10/2019 BAV 2014 PGP Indore Visit I.pptx

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Dec-14 Deepak Kapur 1

Business Analysis and ValuationPGP, IIM IIndore Campus

Term V - 2014

Deepak Kapur

[email protected]


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Changes in Schedule VIpresentation of financial

statements

Applicable to financial statements prepared post April1st, 2011

While presentation of financial statements is not asubject matter of this course, changes introduced have

lead to a problem for analysts in comparing earlier yearstatements with current years

Sheer numerical analysis may lead to incorrectconclusions and hence all analysts must study and

understand the changes introduced in Schedule VIbefore comparing financial data across year

Read the summary document sent as soft copy

Annual Reportsmost exciting reading genre

Is it fiction or non-fiction?


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The following two slides show how the

SAME data looks different under the old

and new format of classification

While balance sheet looks very different

there is no difference in reported net

profit


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OLD FORMAT NEW FORMAT


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OLD FORMAT NEW FORMAT


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Dec-14 Deepak Kapur 6Dec-14 Deepak Kapur 6

What is Intrinsic Value

.. intrinsic value, an all-important concept that offers the onlylogical approach to evaluating the relative attractiveness of

investments and businesses. Intrinsic value can be defined simply:

I t is the discounted value of the cash that can be taken out of a

business during i ts remaining l i fe. The calculation of intrinsic

value, though, is not so simple. As our definition suggests,

intrinsic value is an estimate rather than a precise figure, and it is

additionally an estimate that must be changed if interest rates

move or forecasts of future cash flows are revised. Two people

looking at the same set of facts, moreover - and this would applyeven to Charlie and me - will almost inevitably come up with at

least slightly different intrinsic value figures.

Warren Buffet


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BAV is going to try to . link


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9/99Dec-14 Deepak Kapur 9

Living With Assumptions

BUT
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Price is not Value : Price is NOT Value

Price is what you pay and Value if what you get

The stock market is filled with individuals who know the

price of everything, but the value of nothing."Common Stocks And Uncommon Profits

DO NOT MIX BETWEEN VALUE AND

PRICE



We dont want to know what the other guy will pay

Our aim is to put a fair value to the business we are valuingand not second guess what someone else will pay
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PV Basics

(II)....g-r

r)(1

g)(11

g)A(1g)r,n,PV(A,annuity;endyeargrowingaofPV.5

r

r)(1

11

Ar)n,PV(A,annuity;endyearconstantaofPV4.

.(I)............................................tat timeperpetuitygrowingaofPV3.

ng)capitalisicalled(alsotat timeperpetuityconstantaofPV2.

)1(...)1()1(tat timeflowscashofseriesofPV1.

n

n

n

1

1

2

2

1

1

0

gr

CF

r

CF

r

CF

r

CF

r

CF

t

t

n

n

Note: its cash flow at END of

first year which should be

used in numerator. This

formula can also be writtenas [CF0*(1+g)]/(r-g) where

CF0is the cash flow of just

completed year and which is

expected to grow by g

percent each year



Testing PV Basics

A business currently earns $10mn and this is expected to grow at5% per year for the next five years and thereafter remain constant

at $15mn per year for another 5 years. From the 11thyear onwards

earnings are expected to grow at 5% till perpetuity. Find the value

of the business by discounting earnings at 10%

)05.01.0(

)05.1(*15*

)1.1(

1

1.0

))1.1/1(1(15*

)1.1(

1

05.01.0

))1.1/05.1(1()05.1(*10

55

mn

100 5

What is the value of n? 5 or 6 (Ans: _5)

What is the value of m? 11 or 10 (Ans: 10_)



Try these questionuse discount rate of 20%

A business earned Rs. 5 mn as free cash flow in the justconcluded financial year. What is the PV of a business if

cash flows are expected to be 10 mn each year from next

year onwards till perpetuity

For the above question, what would be the value of the

business if the business had earned 10 mn in the just

concluded financial year instead of 5 mn.

A business is expected to generate 10 mn in free cashflow next year, 20 mn the year after that and thereafter

the free cash flows will grow at 10% perpetually. What

is the present value of the business?



The Importance of Understanding a Business to do

justice to valuation

If I were teaching a course on investing, there would simply be onevaluation study after another with the students trying to identify thekey variables in that particular business and ... evaluating how

predictable they were. because that's the first step..W.E.B

AIM: To understand the risks and drivers in a businessand their effect on cash flow. This is the key to goodforecasting.

It is not possible to do justice to valuation without

understanding the basic characteristics of the business

Remember, firms are just an aggregate of securities andprojects



Understanding Capital, Return on Capital

and various uses of the word value



Book Value of Capital

Capital refers to amount invested to run a business. It could be capital raised from owners (or equity

holders) or from lenders

Capital of Owners as shown in books of accounts also

referred to as: Networth / Shareholders Equity / Equity /

Book Value of Equity

Capital from lenders and owners combined as shown in

books of accounts referred to as: Invested Capital /Total Capital / Book Value of Debt+Equity / Book Value

of Enterprise



Capital

Networth (NW)*

If Calculated From Equity and Liability Side = Share Capital + Reserves& Surplus

If Calculated from Asset Side = All assets Non-Current and CurrentLiabilities

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 lookat 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 ofLong 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 isequity 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 ofinvested capital. Hence Current Liabilities (CL) and other long term liabilities are notincluded as part of it other than short term portion of long term debt.



For Given Data

Calculate

1. Net worth

2. Invested Capital /

Total Capital

3. Assume: Short

Term Portion of

Long Term Debt is

zero unless

otherwise specified



Solution (workings are in Millions)

Networth = 111 + 1126 = 1237 Invested Capital = 1237 + 289 + 854 + 0 = 2405

(in this course we will neglect DTL for the purpose of

calculating Total Capital)



Market value of Capital

EQUITY: As against Book Value of Equitywhich shows the amount of

equity (a.k.a. Networth )as recorded in the books of accounts,market value of equity refers to how much the market is valuingthe equity if the company is listed.

Market value of equity = no. of shares * price per share This is also known as market capitalization.

DEBT

Technically there is a difference between the market value of debt

and book value of debt - but in most cases the two values will besimilar and hence we use book value as proxy for market value

Market value of debt will be the value at which debt is traded ifthe bonds of the company are listed.



Intrinsic value of Capital

EQUITY: Intrinsic Value of Equitythis is the estimate of the true worth of

equity of a business. This is what an analyst seeks to evaluate sothat he can compare the same with market value and decide onbuying or selling. Discounting free cash flows to equity at cost of

equity is the most fundamental method to get the intrinsic value ofequity

DEBT

Intrinsic value of Debt : This can be calculated as the presentvalue of all future interest and principal payments discounted asthe cost of debt of the firm.

Again: for well run firms where there is no distress in debt; theintrinsic value of debt will be close to the book value of debt andhence the latter is used for practical reasons.



Which Value does value of business refer to?

Always be careful of what is being valued

Intrinsic Value Market Value Book Value

Market Price

Value of company can mean either that of standalone or consolidated

company: & could refer to equity valueor enterprise value[debt + equity]. Itcould be the equity value or EV with or without non operating assets. The

person using this term value could be using could be referring to:

The terms market price and market value are interchangeably usedwe 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



So

If someone asks you what is the value of company A, youask him/her which of the following value they are

referring to:

Book Value of Equity

Book Value of Enterprise

Market Value of Equity

Market Value of Enterprise

Intrinsic Value of Equity

Intrinsic Value of Enterprise


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Comparisons which matter in Valuation

Can we compare profit margins across industries (NP margin /Gross Profit Margin)?

Can we compare Return on Investment (RoE or RoIC) acrossindustries?


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Comparisons which matter in Valuation

Can we compare profit margins across industries (NP margin /Gross Profit Margin)?No, comparison of profit margins isuseful for comparing companies within an industry and not across

Can we compare Return on Investment (RoE or RoIC) acrossindustries?yes. Since ultimately investors and entrepreneurs

chase return on investments, it makes sense to compare themacross industries. However investments need not necessarily gointo the industires with highest RoE. Both RoE as well as thequantum of capital that can be deployed have to be studied.


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R I d C i l ( k R T l


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Return on Invested Capital (a.k.a Return on Total

Capital or simple Return on Capital

Choose the correct answer: RoIC = EBIT / (Debt + Equity)

RoIC = EBIDTA / (Debt + Equity)

RoIC = EBIT(1-t) / (Debt + Equity)

RoIC = EBIDTA (1-t) / (Debt + Equity)

R t I t d C it l ( k R t T t l


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Return on Invested Capital (a.k.a Return on Total

Capital or simple Return on Capital

Choose the correct answer:

RoIC = EBIT / (Debt + Equity) RoIC = EBIDTA / (Debt + Equity) RoIC = EBIT(1-t) / (Debt + Equity)

RoIC = EBIDTA (1-t) / (Debt + Equity)

Each of the above definitions used based on the purpose. However for standalone

calculation of Return on Capital, it is the third definition which is most often used.The others are used more for comparative purposes. E.g. if two companies in thesame industry have different depreciation policies and operate in different taxenvironments, it makes sense to use the second definition to compare their returns.

Always remember that the numerator and denominator have to be consistent

they should belong to the same group of stake holders

The earnings of the numerator should have been produced by the capital taken indenominator

Return on Operating and Non Operating Earnings should be measured separately

This will also imply that cost of total capital should be compared to RoIC and cost ofequity to RoE and the two should not be mixed and matched


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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: RoEt= PATt/ Net Wortht RoEt= PATt/ Net Wortht-1 RoEt= PATt/ Average Net Worth(t,t-1)

It Depends on the purpose but in absence of other informationit is the last definition which is most used. However there maybe instances where the second definition is most ideale.g. acompany has done an IPO towards the year end and hence itsreserves and surplus as well as equity capital has shot up

because of this fund raising. In this instance, if we use averagenet worth we would be underestimating the true RoE since thisnew capital has not yet been put to use and hence the PAT doesnot reflect returns from this capital.


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Financial Analysis for Valuation

On the B/S We study the asset side to separate the core and non-core

assets

We then analyze to see how the core and non-core assets are

financed On the P/L

We want to make adjustments for:

Non recurring items

Separate out the core and non-core income, expenses andtaxes.

Also to reflect average normal income from the assets of the

company, we may adjust for capacity utilisation, business

cycle etc.Dec-14 Deepak Kapur 32


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What what RoE and RoIC in

2012?

What is networth in 2011 and

2012?


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Infosys RoE

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 about10976 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

From Database

Actual


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Infosys RoE


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Infosys Restructured BS and P&L

Normalizing the income statement Some of the


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Normalizing the income statementSome of the

Reasons

Business cycle effectsSukhjit Starch, Jindal Poly etc.

To know how much to adjust study historic gross margins or average RoE

To know how long an abnormal period can last study industry demand andcompetitive position; industry dynamics in terms of time required to set up newcapacities

Expense treatment to be correctedApollo Hospitals

One time income / expense Should be eliminated

Financing EffectsInfrastructure Companies / Real Estate companies today

Capacity Utilization Effects

New capacities on streamso depreciation/ other expenses on books but capacities

not fully utilized and scale effects not fully reflected in current statements Other income will not sustain at current levelsReliance Power

Companies which raise fresh cash will have other income till the cash is deployed


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Hawkins CookerNormalization Example

In 20112012 : worker unreast at one of its cooker factories andpollution control issues at another: result was a fall in production.

Supply not enough to meet demand.

Hence FY 2012 PAT does not reflect normal level of PAT and isunderestimating normal PAT.

A quick way to adjust this would be apply average net margins oflast few years to the value of lost sales estimated and add thisfigure to reported PAT.

Reported PAT: 30 crores

Sales lost: about 15% of previous year sales ( prev yr sales = 350cr) = 52 cr.

Average Net Margins: 10%

Adjusted PAT = 30 + 0.1*52 = 35.2 cr.


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Normalizing EarningsOne time item example

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?


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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&Lstatement 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 calculatenormalized PAT. Apart from this all others items on the income statement werenormal in nature and need no further adjustment. What is the normalizedPAT of the company?

Solution:

One time item to be excluded: 100 mn

Tax on this item: 100*0.2 = 20 mn

Hence contribution of this one time item in reported PAT = 80 mn

Normalised PAT = 50080 = 420 mn

Normalized Earnings Expense side adjustment


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Normalized EarningsExpense side adjustment

Example

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?


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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% higherthan reported

Conventions to follow for studying the valuation


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Conventions to follow for studying the valuation

models

For estimating Return on Equity (RoE) or Return onInvested Capital (RoIC)always use the opening (or

previous years closing)Networth or Invested capital in the

denominator for the purpose of studying valuation models

in this course. RoE 2012= PAT 2012/ NW 2011

RoIC 2012= EBIT(1-t) 2012/ IC 2011

Remember IC = Networth + Long Term Loans (includingShort Term Portion of Long Term Loans) + Short Term

Loans


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Fundamental Growth Rates


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Fundamental Growth RateLimits to Growth

Growth will depend on Future opportunities

Amount retained out of earnings

Additional investments

The return generated on these investments

Part growth may be due to inflationary effectszero value growth

Part growth may be due better utilization of existing assets - not sustainable any analyst should ensure that when forecasting financial statements

he cannot forecast all three variable - growth rate, return on capitaland retained earningsindependently. When any two are forecastedthe third is fixed as can be seen from formulae linking the 3 variables.

This kind of check should also be done after valuation is done. We could measure the growth rate in net earnings, EPS or operating

profits.

Remember - Growth can create value only if RoC is greater than CoC


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Earning Per Share growthCase of constant ROE

Expected Long Term Growth in EPS If RoE remains constant

change in earnings = Reinvestment Rate * RoE

Divide both sides by current earnings

gEPS= b*RoE b = Reinvestment rate = Retention ratio = retained earnings / total earnings

RoE = PAT / BV of Equity

We can see from above formula that Growth rate cannot exceedRoE since maximum retention ratio is one (assuming no externalcapital brought in). Hence if a company wishes to grow at a ratefaster than its sustainable RoE it needs to keep raising and

investing capital in excess of its PATi.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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EPS growthchanging RoE

If RoE expected to change and future RoE is RoEt+1then: Change in earnings (i.e EPS of next yrEPS of this year) = newinvst*RoEt+1+ existing invst*change in RoE

i.e. the additional EPS can come from two sources: 1.) the newretained capital earning the RoEt+12) the old capital earning a

some additional (delta) RoE than it was earning before. Divide both sides by current EPS

gEPS= b *RoEt+1+[(RoEt+1RoEt)/ RoEt]

The formula shows how small improvements in RoE can translate

into big growth A company cannot sustain growth simply by improvements in RoE

So the higher the RoE today or more the competition lesser the likelihood ofimprovement in RoE


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Growth in Net IncomeWhen RoE is Stable

Growth in Net Income Use real investments instead of retention ratio

Real investment for total firm = (change in net Long Term Assets + change inWC) : Part of this is funded by equity holders and balance by debt

So, Reinvestment Rate for Net Income = [(net change in PPE + change in WC)funded by equity holders / PAT]

In case of linear growth model where D/E remains stable : for every 100invested in company 100*(1 - D/(D+E)) will be the amount equity holders haveto finance and the balance will be finance by debt holders.

If D/E ratio is 2:1 then if total reinvestment is 600 equity holders share will be600* ( 1-2/3) = 200

Hence, Equity Reinvestment Rate = [(Net Capex + Change in WC) (1D/IC)] / Net

Income, where IC = D+E

gnet income= Equity reinvestment rate * RoE


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Growth in Net IncomeWhen RoE is Changing

Change in PAT = new investment*RoEt+1+ existing

investment*change in RoE( A )

Remember investment means equity investment or networth

since we are interested in growth of PAT

Divide both sides of (A ) by current PAT

Gnet income= equity reinvestment rate *RoEt+1+[(RoEt+1RoEt)/

RoEt

]


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Growth in Operating Income

Stable RoC :

gNOPLAT= reinvestment rate*RoC

Reinvestment rate = [net change in LTA + change in WC]/NOPLAT

RoIC = NOPLAT / [Invested Capital]

Changing RoC :gNOPLAT= reinvestment rate*RoNIC+ [(RoNICRoIC) / 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 spreadover each period

RONICthis is the new overallRoIC after new capital is invested


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Example

Data : Current year is 2012 PAT 2012 = 100

RoE 2012 = 0.2

Change in Networth between 2011 and 2012 = 50

Company will maintain its reinvestment rate in future

Question 1: What is growth rate of PAT in 2013 if RoE

can be maintained in future

Question 2: What is growth rate of PAT in 2013 and2014 if RoE next year and beyond can be maintained at

30%


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Question 1

Question 1: What is growth rate of PAT in 2013 if RoEcan be maintained in future

Solution: Method 1using formula

RoE 2012= PAT 2012/ NW 2011= 0.2; hence NW 2011= 500

Since additional NW in 2012 is 50 the reinvestment rate is50/100 = 50% or 0.5

Since this is a case of stable future RoE expected growth rate in earnings = 0.5 * 0.2 = 10

Solution: Method 2from basics

NW 2012= 500+50 = 550

Since RoE is 20%, PAT 2013= 550*0.2 = 110

Hence growth in PAT = [(PAT2013PAT 2012) / PAT 2012]* 100= (110100)/100 = 0.1 or 10%

Q i 2


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Question 2

Question 2: What is growth rate of PAT in 2013 and2014 if RoE next year and beyond can be maintained at

30%

Solution method 1using formula

Gnet income= equity reinvestment rate *RoEt+1+[(RoEt+1RoEt)/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%

Q i 2


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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 2from 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= (165100)/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%

Will V l D d h T f I ?


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Will Value Depend on the Type of Investor?

1. Marginal Investors

2. Private Equity Investors

3. Buyers of Whole Businesses/New Management

Will V l D d th T f I t ?


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Will Value Depend on the Type of Investor?

1. Marginal InvestorsDiversify Their risk

No say in corporate action

2. Private Equity InvestorsLesser Diversification of Risk

Part say in corporate action

3. Buyers of Whole Businesses/New ManagementConcentrated Risk

Complete Control

Notice the two opposing effects on valuemoreconcentration of risk could mean higher discount rate andhence lower value; more control would require to payhigher

Is a Valuation Exercise Likely to be fruitful


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especially in the context of listed securities?

Efficient Markets?

Rational Investors?

Inefficient Markets?Irrational Investors?



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s a Va uat o e c se e y to be u t u

especially in the context of listed securities?

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

Does Valuation Matter in Investment?


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Does Valuation Matter in Investment?Over time price of securities reflects the underlying intrinsic value

D V l ti M tt i I t t?


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Does Valuation Matter in Investment?

The previous graph shows the 100+ years chart of the Dow JonesIndustrial average on the log scale.

The other lines on the charts are trends in Earnings per unit ofindex, Dividends per unit of index and the Book Value per unit ofindex

As we know earnings, dividends, book value are all indicators ofvalue of underlying asset

The chart clearly shows that over time as these indicators of valueincrease the Price of the asset also shows an increasealbeit in avery volatile manner

The following slide shows a similar chart for the NSE Nifty indexin India over a 11 year period

Notice in both charts as price trend diverges from underlyingvalue trends, sooner or later there is reversion to mean


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Index Vs Earnings and Dividend Yields

0

100

200

300

400

500

600

700

800

Jan-99

Jun-99

Nov-9

9

Apr-0

0

Sep-00

Feb-

01

Jul-0

1

Dec-0

1

May

-02

Oct-0

2

Mar

-03

Aug-03

Jan-04

Jun-04

Nov-0

4

Apr-0

5

Sep-05

Feb-

06

Jul-0

6

Dec-0

6

May

-07

Oct-07

Mar

-08

Aug-08

Jan-09

Jun-09

Nov-0

9

Apr-1

0

Sep-10

Feb-

11

Jul-1

1

Val

ue

Div Yield index close Earnings Book Balue


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Sources of Value

And their link to the competitiveposition of the firm

C titi Ad t


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Competitive Advantages

Contrary to popular belief examples of sustained competitive

advantages are rare

Some sources of such an advantage are

1. Exclusivity by regulations / license

2. Sales based : customer loyalty1. Comes from habit based products

2. High switching or searching costs products

3. Cost Based

1. Production techniques, patents, know how

4. Economies of scale

1. High market share

2. reproducibility


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Q 1) What does Competitive Advantage Mean?Marketing Prof

Q 2) What does Competitive Advantage mean?

Finance Prof

Asking the right questions, seeking the important

information, ability to overlook trivial data - are

very crucial to estimating fair value


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Q 1) What does Competitive Advantage Mean?Marketing Prof

: I dont know

Q 2) What does Competitive Advantage mean?Finance Prof

- It has to help the company earn a sustainable

return of capital in excess of its cost of capital

Terminology


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Terminology

RCA Reproduction cost of Assets LV Liquidation Value of Assets

EPV Earning Power Value (without growth unless

otherwise mentioned)

EPVgrowth Earning Power Value with growth

r Cost of Capital

RoIC Returns on Invested Capital

IC Invested Capital

g growth rate

Sources of Value


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Sources of Value

Every Valuation Model Explicitly or Implicitly goes aboutfinding a value based upon the fact that intrinsic value can

come from:

1. Existing Value of the Assets of the company

2. The existing sustainableEarning Power of the company3. Growing Earning Power from Profitable growth - returns above

its cost of additional capital

Underlines the importance of being able to understand and

judge the competitive position of a company and itssustainability


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1st Source of Value: Asset Value


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1stSource of Value: Asset Value

RULE TWOFor Viable FirmsIn a viable industry:

The Intrinsic Value of Firm is at least equal to reproduction cost of

assets if competitive advantages (CA) exist

The Intrinsic Value of Firm is just equal to reproduction cost of assetsif NO competitive advantages exist

WHY is the above statement true?

Reproduction Cost Value of Assets


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Reproduction Cost Value of Assets

RCA primarily represents the cost of the most efficient wayof reproducing the assets of the existing player Includes investments required in recreating a sales and distribution set up

Includes the time value of money if starting from scratch

Start from Asset Side and Adjust value of all assets torepresent the amount a new entrant would need to invest in

the asset

Look at the liability side and estimate the spontaneous

liabilities the business generates. This effectively reducesthe investment required by new player

Calculate net asset valuethis is the reproduction cost

Liquidation Value of Assets


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Liquidation Value of Assets

Represent the best value a firm could fetch in a fire-sale orstaggered liquidation

Remember it will not be a going concern based value

Assets will fetch a value depending upon what best use they

can be put

2nd Source of Value: Earning Power Value


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2ndSource of Value: Earning Power Value

Earning power means sustainable distributable earnings that may

reasonably be expected over a period of time in the future (almostequivalent to distributable cash flows)

Earning Power Value no Growth = Present Value of currentsustainable earnings(E) capitalized at an appropriate rate (r) EPV = [E / r]

Ignores future growthassumes earnings remain constant The Earnings to Consider are Normalized earnings: These reflect

average sustainable free cash flow numbers based on no growth capexassumptions

This approach is uncontaminated by forecasts of future

Since we are assuming no growth and sustainable earnings r wouldbe close to or slightly above risk free rate


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Earnings Power Value and RCA


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Earnings Power Value and RCA

Three situations for economically viable industries

1. EPV < RCA Management not using assets optimally; Industry operating with excess capacity

Chance to unlock value?

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 !!

3. EPV > RCA Strong barriers to entry or sustainable competitive advantages or great management

(is great management a sustainable comp adv?)

[EPVRCA] = value of franchise

The defining character of a franchise is that it enables a firm to earn more than itneeds to pay for the investments that fund its assets

One has to make a judgment about the sustainability and source of this value

Estimating Equity EPV (no growth value)


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Estimating Equity EPV (no growth value)

The aim is to find normalised average sustainable FCFE from

existing assets, when there is no growth capex.

Start from Net Income and Adjust (on post tax basis) for

1. Any one time expenses or income adjustment

2. Business Cycle adjustments

3. Capacity utilization adjustments

4. Maintenance capex adjustment

5. Leverage Adjustments ( is D/E too high or low than would in stable state?

If yes, then a) interest cost would accordingly have to be adjusted and b)

some cash kept aside to pay off excess debt over timethis has the affect

of reducing FCFE OR some cash will come in from raising more debt over

time and this has the affect of increasing FCFE

If you want to estimate Enterprise EPV on no growth basis adjust

reported post tax EBIT for the above. (Leverage adjustments will

not feature at Enterprise Level valuation)

3rd Source of Value: Value of Growth


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3 Source of Value: Value of Growth

put a value to growth separately in order not to corrupt other estimates

based on bird in hand value.

growth on a level economic playing field adds no valueneed moats

Growth requires new investments- Can Growth Come Without

Additional Investments?

Does Growth bring increase in value?

If RoIC = r : growth produces no value

If RoIC < r : growth will destroy value

If RoIC > r : growth will create value

Growth within a franchise creates valuebecause it implies

sustainable competitive advantage leading to superior returns

This occurs when EPV >> RCA

EPV with Growth: Simple Model


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EPV with Growth: Simple Model

Balanced Growth a change in revenues will imply a proportionalchange in profit

Assets and liabilities required to support this growth will also

grow proportionally

Implies capital required to support this growth growsproportionally

EPVgrowth= IC * [RoIC - g] / [r-g] (this is just the perpetual

growth DCF formula re-written in terms of these variables)

RoIC = r => EPVgrowth= IC

RoIC < r => EPVgrowth r => EPVgrowth>IC

Growth Multiplier


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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

1 1.5 2 2.5 3

0.25 1 1.11 1.17 1.2 1.22

0.5 1 1.33 1.5 1.6 1.67

0.75 1 2 2.5 2.8 3

Three Sources of Value Summary


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Three Sources of Value Summary

Asset value

Reproduction

Cost

Free entry

No comp adv

EPV

Franchise

Value from

current

competitive

advantage

Value of

Growthonly

if growthwithin

franchise

Discrepancies between RCA and

EPV represent both an

opportunity and caution

if EPV < RCA : wil l value unlock?

I f EPV > RCA : wil l competitive

adv sustain?


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Themes on Discounted Valuation Models

2+8=10

4+6=106=10-4

Either Firm Value (Enterprise Value) or Equity


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Value

Enterprise DCF

use free cash flows to firm (FCFF)

These are cash flows prior to debt payments but after meeting all

reinvestment needs for growth assets

The discount rate will reflect the cost of raising both debt and equity capital

in proportion to their use (Weighted Average Cost of Capital (WACC)) Equity DCF

Use free cash flows to Equity holders (FCFE)

These are cash flows from assets after debt payments and after meeting re-

investment needs

The discount rate would reflect the cost of equity (CoE)

Various data bases and books differ in the way they define Free

Cash Flowsthe essence rather than technical definition is

important

Terminology for Firm Valuation Models


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Terminology for Firm Valuation Models

Invested Capital (IC) Capital required for the operations =NW + Long term Debt + Short Term

Debt Operating Profit Operating RevenuesCost of

Revenues= EBIT

NOPLAT Operating profit less operating taxes(NOPLAT = EBI T(1-t)), where t is the

operating tax ratei.e. tax rate of acompletely equity financed firm

ROICt NOPLATt/ICt-1

Investment Rate (IR) Net Investment /NOPLAT

Net Investment ICt+1ICt (if measured from liabilityside) or Change in Net long term assets+ change in working capital (ifmeasured from asset side)

Growth in NOPLAT g = ROIC*IR (when RoIC is stable)

Free Cash Flow Firm (FCFF) NOPLATNet Investment


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Linear Growth Models in ValuationMake it easy

l l i d li


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to learn valuation modeling

Balanced Growth or Linear growth Models a change in revenues will imply a proportionalchange in profit

Assets and liabilities required to support this growth will also growproportionally

Such an assumption makes it easy to study and apply valuation models

So if analyst projects profits to grow 10% then he will also project out capital

to grow 10% if RoC is expected to remain same

V = [FCFt=0* (1+g)] / ( CoC-g)(A) this equation inherentlyassumes linear growth model!!

Since FCF is EBIT(1-t)reinvestment in capex and WC

WE can re-write equation (A) asV = [Capitalt=0 *(RoCt+1g)] / (CoCt+1g)

Where Captial = Networth or Invested Capital depending on whether Vis value of equity or enterprise; similarly CoC will be either CoE orWACC and RoC will be either RoE or RoIC

Fundamental Model for firm value


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Fundamental Model for firm value

For a Company with constant rate of growth of Free Cash Flow(FCF)

The formula below is also known as the value driver relationship,

because it shows the links between the various value drivers and the

value of futurecash flows

gWACC

)RONIC

g(1*NOPLAT

gWACC

IR)(1*NOPLAT

)g)(1*FCFFCFwhereperpetuitygrowingforformulaPVtheis(thisgWACC

FCFValue

1t

1t

t1t1t

This can be rewritten as ICt*(RONIC-g) / ( WACC-g),

where RONIC is the ROIC expected for next year

DCF or Economic Profit Model?


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DCF or Economic Profit Model?

00

0

0

0

1t

1t

1t

ICgWACC

WACCROICIC

gWACC

-WACCWACCROICIC

gWACC

ROICIC

gWACC

)ROIC

g(1*(ROIC)IC

gWACC

)ROIC

g(1*NOPLAT

gWACC

IR)(1*NOPLAT

gWACC

FCF

Value

g

g

Free Cash Flow Definitions


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Free Cash Flow Definitions

Free Cash Flow to Firm or FCFF

FCFF = NOPLAT + DepCapexChange in WC>(A)

Capex = Change in Net Long Term Assets + Depreciation>(B)

Change in WC = WC of current yearWC of previous year

Using (B) the expression ( A ) can be simplified to

FCFF = NOPLATChange in Net LTAChange in WC

Free Cash Flow to Equity or FCFE

I) FCFE = FCFFNet debt repaidpost tax interest payment

Net debt repaid = (opening debtclosing debt)

Post tax interest payment = interest*(1-t)

II) FCFE = PAT + DepCapexChange in WCNet Debt repaid> (C)

Using ( B ) expression ( C ) becomes

FCFE = PATChange in Net LTAChange in WCNet Debt Repaid

FCFE For a Debt Free Firm


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C o a ebt ee

For debt free company

FCFE = PAT + Dep(Change in net long term assets +

Depreciation)Change in WC

FCFE = PAT(change in net long term assets + change in

WC)

For a Debt Free Firm, under linear growth model

assumptions, any change in net worth will total the

change in net long term assets and working capital

Hence FCFE = PATChange in networth

1. Calculate FCFF for year 2011.

2 Calculate FCFE for year 2011


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2. Calculate FCFE for year 2011.


Calculations


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Tax rate2011= Tax / PBT = 4680/15600 = 0.3 or 30%

NOPLAT2011= (PBT+I)*(1tax rate) = (20100(*0.7) = 14070

Depreciation for year = 6500

Change in Net LTA = 8250077000 = 5500

Change in WC = 2030015800 = 4500 FCFF = 14070+6500(5500 + 6500) - 4500 =4070

FCFE = FCFFnet debt repaidpost tax int payment = FCFF -

net debt repaidpost tax int payment = 4070 - ( 55000 - 60000)

4500*0.7 = 5920

FCFE (method 2) = PAT + DepcapexWC change - net debt

paid = 10920 + 6500(5500 + 6500)4500(-5000) = 5920

Terminology


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gy

Economic

Profit

The excess earned on the entire operating capital

over the cost of capital. Similar to EVA for firm.

Economic Profitt = ICt-1* (ROICtWACCt)

Residual

Earnings

The excess earned on the Book Value over the Cost of

Equity. Similar to EVA for Equity.

Residual Earningst= BVt-1*(RoE-CoE)

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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2. Calculate Residual Earnings (RE) for year 2011. CoE 12%,


Solution process


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p

Step 1calculate NOPLAT

Step 2calculate RoIC and RoE

Step 3calculate Economic Profit and Residual

Earnings

Solution


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EBIT 2011 (PBT+ interest) 20100

NOPLAT 2011 14070

IC 2010 92800

WACC 0.1

RoIC on opening capital 0.151616

Economic profit for 2011 4790

PAT 2011 10920

Networth 2010 37800

CoE 0.12

RoE on opening networth 0.288889

Residual Earnings for 2011 6384

Unlevered and Levered CoE


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Levered CoECost of equity for a company as usually

calculated . If the company has debt, the risk and

benefits of debt will reflect in the CoE.

Unlevered CoEThe cost of equity for a company

adjusted for risk and benefits of leverage. In otherwords unlevered cost of equity is the cost of equity for a

company HAD it been totally equity financed.

Frameworks for Discounted Valuation Models


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Model What is

Valued

Discount

Rate

Basis What to

DiscountEnterprise DCF

(FCFFM)

Entire Firm WACC Cash Flows (CFs) Operating CFs

Equity DCF

(FCFEM)

Equity Levered

CoE

Cash Flows CFs to Equity

Economic Profit

(EPM)

Entire Firm WACC 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)

Entire Firm Unlevered

CoE

Cash Flows Operating CFs

Discounted Cash Flow Based Valuation Models


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APV = PV of FCFF + PV of tax shieldsPV of bankruptcy cost =

FCFF (for FCFF use unlevered CoE as discount rate / for tax shields

its cost of debt or unlevered CoE)

APV (MM

Theorem)

DDM

FCFE

FCFF

nt

t

t

t

CoE

FCFEValueEquity

1 )1(

nt

tt

t

CoE

DiveEquityValu

1 )1(

All Models (other than DDM) will give the same value. Equivalence will hold IFF you make

consistent assumptions

nt

tt

t

WACC

FCFFFirmValue

1 )1(

Interest Tax Shield


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Interest is a genuine business expense and is hence tax deductible.

This means that tax is calculated only after deducting interestfrom operating profits. So if an equity financed firm has PBIT of

100 and tax rate is 30% it pays 30 as tax since its PBT = PBIT. If

the same firm had debt and interest was 20 then PBT would 80

and tax would be 24. hence tax savings due to interest = 6 whichnothing but tax rate* interest = 20*0.3 = 6. This is also known as

interest tax shield. Since it reduces tax outgo its increasing cash

flows and hence adds value.

Enterprise DCF and APV give the same value but only differ in

the way they calculate the PV of interest tax shields

Where in Enterprise DCF are we accounting for the interest tax

shield?

In the WACCremember we use post tax cost of debt

Discounted Accounting Based Valuation Models


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nt

tt

ttt

WACC

WACCROICICICFirmValue

01

110

)1(

)(

ResidualEarnings

Model

DiscountedEconomic

Profit Value

nt

tt

ttt

CoE

CoEROEBVBVeEquityValu

01

110

)1(

)(

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