1

A REPORT

ON

VALUATION METHODS

By

Arjun Vikas 2011A1PS430P

AT

A Practice School II Station of

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE, PILANI

(March, 2015)

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A REPORT

ON

VALUATION METHODS

By

Name of the student(s) ID No(s) Discipline(s)

Arjun Vikas 2011A1PS430P Chemical Engineering

Prepared in the partial fulfillment of the

Practice School II Course

AT

A Practice School II Station of

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE, PILANI

(March, 2015)

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ACKNOWLEDGEMENTS

I am indebted to my manager and guide Mr. Gaurav Surana, Vice President and Head of

Mergers & Acquisitions Team for his valuable inputs and help provided during my work at

JP Morgan.

I would also like to extend my gratitude towards Mayank Kumar who has been cordial

enough to manage our internship and provide valuable inputs regarding our progress at JP

Morgan.

I would also like to thank my mentor Viral Shah for providing his deep insight about the

topic and explaining to me the entire concept of discounted cash flows.

I would also like to express my appreciation for Mr. Vijay Reddy, co-ordinator of the PS

program in Mumbai, and Mr. Krishnamurthy Bindumadhavan , my PS instructor, for all their

efforts in organizing the program, including the different evaluation components as well as

for making sure that it is convenient for us.

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BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE

PILANI (RAJASTHAN)

Practice School Division

Station: JP Morgan Services Centre: Mumbai

Duration: 5 Months Date of Start: 12th

Jan 2015

Date of Submission: 18th

June 2015

Title of the Project: Valuation Methods

ID No./Name(s)/: 2011A1PS430P Arjun Vikas Chemical Engineering

Discipline(s) of the

Student(s)

Name(s) and: Gaurav Surana

Designation(s): Vice President

of the expert(s)

Name(s) of the: Krishnamurthy Bindumadhavan

PS Faculty

Key Words: Discounted cash flow, Relative Valuation (Transaction & Trading

Comparables)

Project Areas: Financial Management

Abstract:

JP Morgan uses various financial models to assess the viability of a particular investment.

DCF or discounted cash flows is an important valuation model used at JP Morgan. DCF uses

future free cash flow projections and discounts them (most often using the weighted average

cost of capital) to arrive at a present value, which is then used to evaluate the present worth of

the company. Relative valuation is another frequently used tool for valuing companies. It

uses various ratios like P/E, EV/EBITDA to calculate the worth of the companies. This is

arrived at using the comps models developed at JP Morgan.

Signature(s) of Student(s) Signature of PS Faculty

Date

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Contents

Introduction ............................................................................................................................................................ 6

DCF Model ............................................................................................................................................................. 7

Time Value of Money ......................................................................................................................................... 7

WACC ............................................................................................................................................................ 7

Dividend Discount Model ................................................................................................................................... 8

Free Cash Flows ................................................................................................................................................. 8

EBIT (1-T) or NOPAT(Net Operating Profit After Tax) ............................................................................... 9

Depreciation & Amortization ......................................................................................................................... 9

Change in Net Working Capital...................................................................................................................... 9

Capital Expenditure .......................................................................................................................................... 10

Initial Cash Flow .......................................................................................................................................... 10

Terminal Cash Flow ..................................................................................................................................... 10

Analysis ............................................................................................................................................................ 11

Benefits ................................................................................................................................................................. 11

Drawbacks ............................................................................................................................................................ 11

Topics Remaining ................................................................................................................................................. 12

Sources ................................................................................................................................................................. 13

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INTRODUCTION

Discounted cash flow analysis is a method of valuing a project, company, or asset using the

concepts of the time value of money. All future cash flows are estimated and discounted by

using cost of capital to give their present values (PVs). The sum of all future cash flows, both

incoming and outgoing, is the net present value (NPV), which is taken as the value or price of

the cash flows in question. The cash flows are discounted based on the weighted average cost

of capital (WACC) which acts as the discount rate.

The formula for calculating DCF is given by:

PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)

n-1

Where:

PV = present value

CFi = cash flow in year i

k = discount rate/WACC

TCF = the terminal year cash flow

g = growth rate assumption in perpetuity beyond terminal year

n = the number of periods in the valuation model including the terminal year

The DCF model is frequently used in both macro and micro scale, from outright purchase of

a new company to purchase of a machine. The cash flows which will be considered in the

report are the free cash flows which can be calculated as operating profit + depreciation +

amortization of goodwill - capital expenditures - cash taxes - change in working capital.

Relative Valuation is a business valuation method that compares a firm's value to that of its

competitors to determine the firm's financial worth. Relative valuation models are an

alternative to absolute value models, which try to determine a company's intrinsic worth

based on its estimated future free cash flows discounted to their present value. Relative

valuation is done by comparing ratios such as P/E, EV/EBITDA, EV/Sales, etc for the peers

of the company that one is trying to value. These multiples are arrived at using either trading

or transaction comps. The multiples used in trading or transaction comparable are same i.e.

EV/EBITDA, EV/SALES, P/E. Trading multiples are obtained for companies that trade on

the market, effectively public companies whereas transaction comps compare transactions

that happen(acquisitions) and the price buyer pays, to derive the multiples.

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DCF MODEL

Time Value of Money

The idea that money available at the present time is worth more than the same amount in the

future due to its potential earning capacity. This core principle of finance holds that, provided

money can earn interest, any amount of money is worth more the sooner it is received.

In simple terms $100 today is worth more than $100 tomorrow because the money is always

depreciating. This is known as time value of money.

The present value (PV) formula has four variables, each of which can be solved for:

There is a certain rate at which the money is depreciated and that is known as discount rate or

weighted average cost of capital (WACC) in our case. Another variable that needs to

specified is the time period or the intervals at which money is expected to be received.

WACC

The weighted average cost of capital (WACC) is the rate that a company is expected to pay

on average to all its security holders to finance its assets. The WACC is commonly referred

to as the firm’s cost of capital. Importantly, it is not dictated by management. Rather, it

represents the minimum return that a company must earn on an existing asset base to satisfy

its creditors, owners, and other providers of capital, or they will invest elsewhere.

The rate for debt and equity differ as the risks on them are different. A general formula for

calculating WACC is:

WACC = ke (E / A) + kd (1 – T) (D / A)

Where:

ke = rate of return on equity

kd = rate of return on debt

E = amount of equity raised

D = amount of debt raised

A = E+D

T= tax rate

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Dividend Discount Model

It’s the simplest model for valuing equity-- the value of a stock is the present value of

expected dividends on it. While many analysts have turned away from the dividend discount

model and viewed it as outmoded, much of the intuition that drives discounted cash flow

valuation is embedded in the model. In fact, there are specific companies where the dividend

discount model remains a useful took for estimating value.

The General Model

When an investor buys stock, he generally expects to get two types of cashflows- dividends

during the period she holds the stock and an expected price at the end of the holding period.

Since this expected price is itself determined by future dividends, the value of a stock is the

present value of dividends through infinity.

The above formula is also called the Gordon Growth Model.

The rationale for the model lies in the present value rule - the value of any asset is the present

value of expected future cash flows discounted at a rate appropriate to the riskiness of the

cash flows.

There are two basic inputs to the model - expected dividends and the cost on equity. To

obtain the expected dividends, we make assumptions about expected future growth rates in

earnings and payout ratios. The required rate of return on a stock is determined by its

riskiness, measured differently in different models - the market beta in the CAPM, and the

factor betas in the arbitrage and multi-factor models. The model is flexible enough to allow

for time-varying discount rates, where the time variation is caused by expected changes in

interest rates or risk across time.

Limitations:

The Gordon growth model is a simple and convenient way of valuing stocks but it is

extremely sensitive to the inputs for the growth rate. Used incorrectly, it can yield misleading

or even absurd results, since, as the growth rate converges on the discount rate, the value goes

to infinity

Free Cash Flows

Free cash flows are a measure of financial performance calculated as operating cash flow

minus capital expenditures. It represents the cash that a company is able to generate after

laying out the money required to maintain or expand its asset base. Free cash flow is

important because it allows a company to pursue opportunities that enhance shareholder

value. Without cash, it's tough to develop new products, make acquisitions, pay dividends

and reduce debt.

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FCF can be divided into FCFE(Free Cash Flow to Equity) & FCFF(Free Cash Flow to Firm):

FCFE

This is a measure of how much cash can be paid to the equity shareholders of the company

after all expenses, reinvestment and debt repayment.

Calculated as: FCFE = Net Income - Net Capital Expenditure - Change in Net Working

Capital + New Debt - Debt Repayment

FCFF

A measure of financial performance that expresses the net amount of cash that is generated

for the firm, consisting of expenses, taxes and changes in net working capital and

investments.

Calculated as:

Explanation of the terms:

EBIT (1-T) or NOPAT(Net Operating Profit After Tax)

EBIT (1-T) is the income generated by the operating activities after deducting the tax from

the operating profit.

The sales from the new investment is calculated by various estimation methods and then its

operating costs are deducted like the cost of goods sold and selling, general and

administrative costs, We then arrive at the EBIT from which the tax is deducted to obtain the

first component of free cash flows.

Depreciation & Amortization

This is an important step in the DCF analysis. Depreciation & Amortization or D&A is the

reduction in the value of an asset over the period of time due to wear and tear or reduction in

goodwill in case of intangible assets. Depreciation is for tangible assets and amortization is

used for intangible assets. There are also various models for calculation of these components

which will not be discussed in this report.

D&A is subtracted from gross profit to arrive at EBIT and then again subtracted from the

after tax EBIT as these are not considered operating cash flows.

Change in Net Working Capital

Changes in Working Capital is the net change in current assets and current liabilities.

Working Capital is a measure of a company's short term liquidity or its ability to cover short

term liabilities. Working capital is defined as the difference between a company's current

assets and current liabilities.

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Working Capital = Current assets – Current liabilities

Capital Expenditure

Initial Cash Flow

Every investment requires an initial cash flow as it is required to purchase a product or a

company in a macro level. The amount of money spent on the investment initially is the

initial cash flow. In some cases there may be an exchange involved or selling of assets which

will produce a positive effect on the initial cash flow. This is a cash flow which is in present

and thus do not have to be discounted.

Terminal Cash Flow

Terminal cash flow is generally a positive cash flow unlike initial cash flow. It is the amount

of cash generated by selling of the investment or after the investment has run its due course.

It is the last cash flow in the DCF model is the one which has the maximum impact from the

discount rate.

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Analysis

After obtaining all the cash flows and the discount rate we apply the discounting formula and

obtain the final net present value of the investment.

If NPV > 0 then the investment is profitable and should be undertaken

If NPV < 0 then the investment is not profitable and thus should be forfeited

Also in case of companies this model can be used to calculate their future cash flows and

subsequently their values.

Suppose ABC Company is having an interest in XYZ Company and wishes to acquire it.

In the DCF model the operating cash flows will be effected as the sales and operating costs

will be different and there will also be a huge initial cash flow because of the acquisition cost.

This will lead to a final table of cash flows which will be used to calculate the internal rate of

return and if the IRR > WACC then the acquisition should be done otherwise scrapped.

BENEFITS

Accounting scandals and inappropriate calculation of revenues and capital expenses give

DCF model of valuation new importance. With heightened concerns over the quality of

earnings and reliability of standard valuation metrics like P/E ratios, more investors and

analysts are turning to free cash flow, which offers a more transparent metric for estimating

performance than earnings.

Developing a DCF model demands a lot more work than simply dividing the share price by

earnings or sales. But in return for the effort, investors get a good picture of the key drivers of

share value: expected growth in operating earnings, capital efficiency, balance sheet capital

structure, cost of equity and debt, and expected duration of growth.

DRAWBACKS

Discounted cash flow models are powerful, but they do have shortcomings. Small changes in

inputs can result in large changes in the value of a company. Investors must constantly

second-guess valuations; the inputs that produce these valuations are always changing and are

susceptible to error.

Meaningful valuations depend on the user's ability to make solid cash flow projections. While

forecasting cash flows more than a few years into the future is difficult, shaping results into

eternity (which is a necessary input) is near impossible. A single, unexpected event can

immediately make a DCF model obsolete. By guessing at what a decade of cash flow is

worth today, most analysts limit their outlook to 10 years

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Topics Remaining

I will be covering Relative Valuation in detail in the remaining months. That will include

Trading & Transaction Comps in detail.

Overview of Relative Valuation:

Relative Valuation is a business valuation method that compares a firm's value to that of its

competitors to determine the firm's financial worth. Relative valuation models are an

alternative to absolute value models, which try to determine a company's intrinsic worth

based on its estimated future free cash flows discounted to their present value. Relative

valuation is done by comparing ratios such as P/E, EV/EBITDA, EV/Sales, etc for the peers

of the company that one is trying to value. These multiples are arrived at using either trading

or transaction comps. The multiples used in trading or transaction comparable are same i.e.

EV/EBITDA, EV/SALES, P/E.

Trading multiples are obtained for companies that trade on the market, effectively public

companies whereas transaction comps compare transactions that happen(acquisitions) and the

price buyer pays, to derive the multiples.

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Sources 1. Investopedia

2. Wikipedia

3. Security Analysis and Portfolio Management (English) 1st Edition- S. Kevin

4. Damodaran on Valuation- A. Damodaran