projecting financials & valuations

8/8/2019 Projecting Financials & Valuations

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Projecting Financials &

Valuation


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Agenda

Management Interaction

Projecting Financials

Estimating Growth Estimation of Discount Rates

Estimation of Cash flow

Valuation Discounted Cash flow Analysis

Relative Valuation


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Agenda

Valuation

Valuation of Mergers and Acquisitions

Choosing the right valuation tool Market Perspective on Relative valuation

Giving Recommendation

Analyzing Financial Services Companies


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Futuristic Questions

Focused on the broader areas that give you senseof what lies ahead

Strategy: Plans of entering into new businesses

New client acquisition

Technology & its impact on the business & margins

Inorganic acquisition Market share strategies

Rationale behind new geographical forays

Etc.


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Finance

Expected growth in revenue (management may

not always tell this, so indirect questions asking

the same in like will you grow at minimum of

industry growth rate, etc.)

View of margins and factors affecting it

Any funding plans, ways of funding Pricing strategy

Volume etc.


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Building the revenue model Identifying the key revenue drivers

Identifying the Volume measure

Identifying the Pricing measure

Business model Should be most comprehensive

Nature of the business

For e.g. in IT sector there are multiple drivers Geographical breakup (US, Europe, India and RoW)

Location of work: Onsite-Offshore Service Lines

Domains of work etc.

Key driver, however, is the employee base. How?

Building the Infosys revenue model.


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Key revenue drivers in different industries

Telecom

Real Estate

Infrastructure Automobile

Auto ancillary

Banking

Media

FMCG

Retail & Hospitality


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Building Cost Models Identifying the key costs

Direct costs Labor

Material Basis for projecting:

Capacity expansions, if any

New geographical forays (lower labor costs, availability material etc)

Acquisitions etc.

Also see the trends expected in the raw material prices.

Indirect Costs Selling and Marketing Expenses Need to verify the market & economy scenario

Look at the historical trends and see any cyclicality

General & Administration Expenses


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Depreciation: Always project the Depreciation

as a % of average gross block.


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Projecting the Other Income

See the schedules to get the break up of the otherincome. It typically comprises:

Interest on deposits (Cash &B

ankB

alance) Dividend on investments (Liquid investments like

MF, others etc)

Others

Typically, project the entire other income based on the cash,bank balance & liquid investments

Projecting Interest Expenses: as % of the loan

Extraordinary Income: Do not project unless youhave high level of conviction about it arising.


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Taxes: Project the taxes based on the

management discussions and as % of PBT.

Minority Interest: Ideally, you should projectthe numbers of the subsidiary and consolidate

it with the parent company. However, if the

subsidiary is not big enough, project minority

interest as % of PAT (before Minority iterest)


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EPS

Projecting the Number of Shares

Factor in the issue of new shares

ESOP conversion

Factor in what proportion of the debentures will get

converted into equity shares

Inputs from management will be quite valuablefor projecting the diluted EPS.


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Dividends: The company board decides thedividends. Typically, the companies in growthphase would give lower dividends and those inmature phase will give higher.

Dividends can be projected as % of PAT or as % ofEquity Capital. Always get feedback from themanagement as to what do they refer internally.

Typically, the companies will not lower thedividends as it is considered a major negativeunless it is able to justify the investors the reasonfor lowering the dividends.


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Gross Block

Project Capital Expenditure:

get inputs from the management

See the expansion plan See historical trend in capex per key parameter

(number of user, towers, customers, employees, etc.)

Have some basis like revenue target, market sharetarget, etc.

Get cues from the announcements done by themanagement etc.

Next Year Gross Block = Last Y Gross Block + Capex


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Accumulated Depreciation:

Last year Accumulated Depreciation + Current

year Depreciation

Computing Capital Expenditure:

Increase in Gross Block + Increase in Capital Work

in Progress + Increase in Goodwill

Increase in net block + Current year Depreciation+ Increase in Capital Work in Progress + Increase in

Goodwill


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Current Assets:

Debtors

Calculate the debtor days. Look at historical trends. Look at

the current market trends. Look at the competition. See howis company placed vis--vis in the coming days. Check new

product launches, if any. Have some rationale assumptions

over their success rates. Based on that predict whether the

company will be more aggressive or liberal.

Cash has to be the balancing figure. Look at the value

of cash. If it is fluctuating by great value, get that

there are other assumptions that are getting wrong.


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Inventory

Calculate the inventory days. Interact with the

management. See the market scenario. Have a

view on the demand-supply scenario. Based onthat project the inventory.


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Creditor Days:

Calculate the creditor days based on (typically)total costs involved. It should ideally be calculated

on the net purchases. However, if the creditorsinvolve all sorts of entries, it should be calculatedon the total operating costs/ total direct costs.

With the best judgment of whether the company

is in position to ask for higher credit period,project the creditor days and reverse calculate thecreditors.


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Provision for Dividends:

Project it as % of the total dividends paid

Provision for Taxes Project it as % of the total taxes paid

Other provisions: See its relevance for the

balance sheet. See how big is the value.

Identify the proper driver for it and project.


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Projecting For next 5 years

It is a difficult task indeed. However, you need to

foresee and make the rationale assumptions.

One of the ways could be to assume that the

company will maintain the same market share in

the industry. And using the industry forecasts that

are publicly available.B

ut you must be able tosupport your assumptions with other solid data.


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Some basic principles:

Always take the denominator figure as the averageof last two years.

Always keep a tab on the common sized P&L andBalance sheet to see whether your projections aregoing haywire.

Do not waste too much time on one entry at a

time if the projected number does not make muchof a sense.

Not all things will ever be clear for you


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Estimating Growth

Types:

Look at the firms past earnings i.e. its historical

growth rate

Looking at the analysts growth estimates

Fundamental growth of the firm from its

reinvestment


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Estimating Growth

Historical Growth

Arithmetic Versus Geometric Averages

Linear and Log-linear regression models

Time-series to model EPS

Usefulness of Historical growth

Revenue growth Vs Earnings growth

Effects of Firm size

Example


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Estimating Growth

Analyst Estimates What gets covered?

High market capitalization

Institutional Holding

Trading Volume

What is different about the analyst forecasts? Firm specific information that has been made public since the

last earnings report

Macro economic information that may impact future growth

Information revealed by competitors on future prospects

Private information about the firm

Public information other than earnings


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Estimating Growth

Fundamental Determinants Growth = Function ( Reinvestments & its

quality)

gt = (NIt- NIt-1)/ NIt-1

gt: Growth rate in net income

NIt : Net income in year t

By Definition:

NI(t-1) =B

V(t-2) *RoE (t-1)

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

RoE t


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Estimating Growth

Fundamental Determinants

Assuming RoEt=RoEt-1=RoE

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

= Retained Earnings t-1/ NIt-1*RoE

= b * RoE

Where b is retention ratio.


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Free Cash FlowModels


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Valuations

Three Basic Questions

Why do you value a Company?

What do you value in the company?

How do you value a company?


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Valuation

Why do you value a company?

To arrive at the decision on Buy or Sell shares of a

company

To assist you in evaluating whether the value is

getting created or not

To identify the merger or acquisition target

To value the synergy post merger/ acquisition


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Valuation

What do you value in the company?

You can value inventory

You an value the project the company has taken

up

You value the corporate bonds

You can value the managers (value manager)

You can value Equity of the company

You can value the entire firm itself


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Valuation

Approaches to Valuation Discounted Cash Flow Valuation

Dividend Discount Models

Free Cash flow to Equity Models

Free Cash flow to Firm

Relative Valuation Price/ Earnings Multiple

Price/ Sales Multiple

Price/ Book Value Multiple

EV/ EBIDTA Multiple

EV/ Sales Multiple


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Valuation

Computing Discount Rate

It is also called as Expected Rate of Return (ERR)

If you are valuing an equity, it is called as cost of

Equity.

If you are valuing debt, it is cost of debt.

If you are valuing a firm, it is called as Cost of

Capital. So, how do you compute it?


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Valuation

Computing Discounting Rate CAPM

CoE = Rfr+ Beta * (RmRfr)

Rfr is a risk free rate

Beta is the measure of the covariance of stock returns withthat of the market index

Rm is market return

The equation is based on several Assumptions: Investors have homogeneous expectations about asset returns

and variances They can borrow and lend at risk free rate

There are no transaction costs

There are no restriction on short selling


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Valuation

Computing Discounting Rate

CAPM

Risk premium (Rm-Rfr) is the difference between the averagestock returns and the returns on the risk free securities.Typically, the use of longest period seems appropriate.Moreover, the use of geometric mean rather than arithmeticmean takes care of the compounding effect.

Risk premium can vary depending on a. variance inunderlying economy b. Political risk c. Structure of the

market. In country like India typically the risk premium is assumed to

be between 7-8%.


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Valuation


CAPM

Risk Free Rate

A short term T-Bill Rate

Current short term government security rate

Current long term government-bond rate

In most valuation cases, the risk free rate that is considered is

the one for long term government bond rate.

In India the long term government rate is: xxxxxx


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Valuation


CAPM

Beta: There are 4 points that need to be considered

while estimating Beta. Length of Estimation Period: A long period provides more data

but the firm itself might have changed in its dynamics.Typically, a 5 years of data is advisable

Return Interval: Daily, Weekly, Monthly, etc. Non-Trading bias.Weekly, Monthly data is advised as it helps removing non-

trading periods. Choice of Index

Errors involved in computing Beta.


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Valuation


CAPM

Determinants ofBeta

Type ofBusiness: Cyclical businesses have higher betas. Beta

of a firm operating in different businesses will have betas that

are weighted average of betas of the respective business lines.

Degree of Operating Leverage: A degree of operating leverage

is function of the cost structure of the firm and is usually

defined in terms of the relationship between the fixed costsand the total costs. The firm that has higher operating

leverage, i.e. higher proportion of fixed costs in total costs will

have higher variability in EBIT


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Valuation


CAPM

Determinants ofBeta

Degree of operating Leverage: Firms A&B. Firm A has 40% of

its costs variable and firm B has 60% of its costs variable. For

expected revenue of Rs125mn, Boom revenue of Rs200mn

and recession revenue of Rs80mn, the EBIT will be as follows:

Costs in Rs mn EBIT in Rs mn

Firm Fixed VariableFixed/Total Expected Boom Recession

A 50 50 0.5 25 70 -2

B 25 75 0.25 25 55 7


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Valuation


CAPM

Determinants ofBeta

Financial Leverage: Other things remaining equal, increase in

financial leverage will increase the equity beta of a firm.

Intuitively, increase in the payment of interest expense will

increase the earnings during the boom time and would impact

badly during recession. If the having debt on the balance

sheet is giving tax advantage to the firm, then the Beta can becomputed as:

BetaL = BetaUL *(1+(1-t)*(D/E))

Computing Unlevered Beta Assignment.


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Valuation


Arbitrage Pricing Model (APM)

This is used to have further accurate estimate of the

cost of Equity.

It is given by

j=n

CoE= Rfr + Betaj * (E(Rj)-Rfr)j=0

Where Rj is the return on every factor j having Betaj


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Valuation

Computing Discount Rate

According to Grodon Growth model,

P0 = DPS1/ (Ke- g)

So, Ke = (DPS1/ P0) + g

However, using this Ke will always justify the current

price given that is has been computed from thesame.


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Valuation

Computing Discounting Rate Weighted Average Cost of Capital

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

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

Computing Cost of Debt, Kd Current level of interest rates: Typically, as the level of interest

rates increases, the cost of debt also increases.

Default risk of the company: As the default risk of the companyincreases, the Kd also increses. If the ratings go up, the Kd willreduce and vice a versa. If the ratings are not available, use therecent interest rates paid by the firm.


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Valuation


Computing Cost of Debt, Kd

The tax advantage with the debt: As the interest paid

on the debt is tax deductible, the after tax cost of debtwill be lower than the pre-tax cost of debt.

After Tax Kd = Pre-tax Kd *(1-t)


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Valuation

Estimation of Cash flows

Cash flow to equity

Investor in a firm are entitled to get residual cash flows

from the firm after meeting its all the obligations,including debt payments and after meeting the

reinvestment needs of the organization. So, the cash

flow remaining after operating expenses, interest and

principal payments, and any capital expenditureneeded to maintain the growth rate in projected cash

flow.


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Valuation


Cash flow to equity

Unlevered Firm

Revenues Operating expenses

= EBITDA

- Depreciation & amortization

= EBIT- Taxes

= Net Income + Depreciation & Amortization= Cash flows from operations Capital Expenditure working capital

needs

= Free cash flow to equity


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Valuation


Cash flow to equity

Unlevered Firm

The Free cash flow to equity can be negative. In that case, the

company needs to come up with the new issue or private

companies need to raise funds from the owners or the

venture capitalists. It can be positive and dividends can be

paid, though not always.

Depreciation: It is a non-cash expenses and also taxdeductible. They provide tax benefit to the extent of:

Depreciation * marginal tax rate


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Valuation


Cash flow to equity

Unlevered Firm

Capital Expenditure: A portion of the operating cash flow has

to be invested in maintaining the existing assets and to create

new growth assets. Since the benefits of the growth are

usually reflected in cash flows, so we need to reflect the costs

incurred to create the growth assets in the cash flow.

Relationship between Capex & Depreciation: Firms in highgrowth phase have capex that exceeds the depreciation.

While for the firms in stable growth phase, capital

expenditure and depreciation are at par. This implies that the

ratio of capex to depreciation should decline as the firm

moves from high growth to stable growth phase.


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Valuation


Cash flow to equity

Unlevered Firm

Working Capital requirements: Since the funds tied up in theworking capital can not be used anywhere else, they have to beconsidered while computing the cash flow.

Increase in working capital are cash out flows and decreases arecash inflows.

Treatment of cash: By definition, the cash is included incomputation of working capital. However, if the cash is not beingused for the day to day operations of the company, it should notbe considered in computation of working capital. Typically, 2-3%of sales can be considered as normal cash. Mere increase in cashcan not be considered as cash outflow.

Higher the growth, typically, higher will be the working capitalneeds. WC needs also change from business to business.


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Valuation

Estimation of Cash flows Cash flow to equity

Levered Firm (Optimal D/(D+E) Ratio)

Net Income

+ Depreciation & Amortization= Cash flow from operations Capex

- Working capital requirements

- Principal Payments

+ Proceeds from new debts

= Free cash flow to equity Here it is assumed that the principal payments will be done

from the new debt issues.


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Valuation


Cash flow to equity

Levered Firm (Optimal D/(D+E) Ratio)

And hence,

Net income

(1-D/(D+E)) * (Capex- depreciation)

(1-D/(D+E)) * Working capital changes

= Free cash flow to equity


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Valuation


Cash flow to equity

Levered Firm (Above Optimal D/(D+E) Ratio)

Here, the firm may have to generate disproportionately higher

equity in financing its investments needs to reduce its debt

ratio. It may have to generate funds to repay its principal.

Here, proceeds from the new debt will be lower than:

Principal Payments + * (Capital Expenditure + Working Capital

needs)

Example


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Valuation


Cash flow to Firm: In general terms the cash flowto the firm are the earnings after operating

expenses and tax but before paying to any claimholders.


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Valuation

Claim Holder Cash flow to claim holder Discount Rate

Equity Investor

Debt Holders

Free Cash Flow to Equity

+

Interest Expenses (1-t) +

Principal Payments

- New Debt Issues

Cost of Equity

After Tax

Cost of Debt

Preferred Stock Holders Preferred Dividends Cost of Preferred Dividends

Firm = Equity Investors + Debt

Holders + Preferred Stock

holders

FCFF= Free Cash Flow to

Equity + Interest Expenses (1-

tax rate) +Principal

Repayments New Debt

issues + Preferred Dividends

Weighted Average Cost of

Capital


Cash flow to Firm


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Valuation

Discounted Cash Flow Models Dividend Discount Models

When individuals buy stocks, they expect returns in terms ofthe expected dividends and the appreciation of the stock

price. So, the hypothesis is that the price itself is the function of

the future expected dividends till infinity.j=n

Price = DPSj / (1+r)j

j=0

DPSj is expected Dividend per share.r is required rate of return on the stock.

To identify the future dividends, the assumptions for thefuture growth rates in earnings and payout ratios are made.


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Valuation

Discounted Cash Flow Models

Dividend Discount Models (DDM)

CAPM is used to identify required rate of return and

assumptions about different variables like Beta,Riskfree rates are made.

Versions of the DDM

Gordon Growth Model

Two Stage DDM

Three Stage DDM


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Valuation


DDM

Gordon Growth Model

Value of Stock = DPS1 /( r- g) DPS1 is Dividend per share for next year

R is required rate of return for equity investor

g is perpetual growth rate

0

1

2

3

4

6

FY10 FY11E FY12E FY13E FY14E FY1

E

Stable Growth rate

g %


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Valuation


DDM

Estimating stable growth rate

As the dividend is expected to grow at a stable rate forever, firms

other measures are also expected to grow at same rate. For if, thedividends grow at a higher rate (say 8%) than earnings (say 6%),over the years, dividends will exceed the earnings. In the reversecase, the dividend payout will converge to zero, which is not asteady state.

The expected growth rate can not be greater than the economys

nominal growth rate as, if it continues, the company will bebigger than the economy over the years, that is quite irrational.Hence the stable growth rate should be around the economy snominal growth rate.


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Valuation


DDM

Estimating stable growth rate

In country like India, the nominal growth rate in the economyin the long term will be say 2-3% with expected inflation of 4-

5%. So, the stable growth assumption should vary too much

from 6-8%. The growth rate can not be more than 1-2% above

the growth rate in economy.

Limitations of the Model It is extremely sensitive to the input of growth rate.

Example


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Valuation


DDM

Two Stage DDM

Here, it is estimated that the growth happens in two stages.

First few years of higher growth rates followed by the stable

growth rate

High Growth Phase gh Stable growth phase gn


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Valuation

Discounted Cash Flow Models DDM

Two Stage DDM The value of the stock is given by:

Present value of high growth phase + Present value of TerminalValue.

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

+DPS0 *(1+gh)^n *(1+gn)/ ((r-gn)*(1+r)^n)

[PV of terminal value]


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Valuation

Discounted Cash Flow Models DDM

Two Stage DDM Limitations

In this model, it is assumed that the high growth phase will fall to a

stable phase abruptly. Also, in the stable growth phase, the payout is expected to go up

significantly.

Moreover, other parameters like Beta, RoA, etc. are expected to beinline with the stable growth phase.

It is difficult to estimate the length of the high growth phase and thevalue of the high growth itself.

The terminal value contributes a large portion of price and it issensitive to assumptions of the stable growth rate.

est Uses: In the pharmaceucitcal company whose patent is about thelapse in the nth year.

Example


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Valuation


DDM

Three Stage DDM

Value of the stock price =

high growth phase + Transition Phase + Terminal Value

0%

2%

4%

6%

8%

10%

12%

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

growth %


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Valuation


DDM

Three Stage DDM

Example


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Valuation


Free Cash Flow to Equity (FCFE)

Net Income + Deprecation Capital Spending -

Working Capital Principal Payments + New DebtIssues

For levered firm with optimal debt ratio,

Net Income + (1- ) * (Capital Spending Deprecation)

(1- ) * Working Capital


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Valuation


Free Cash Flow to Equity (FCFE)

Why dividends different from FCFE?


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Valuation

Relative Valuation

Price to Earnings Multiple

Estimating P/E ratio from the fundamentals

P0 = DPS1/ (r-g)

Replace DPS1 by EPS0 * (1+g) * Payout Ratio

So,

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

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


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Valuation

Relative Valuation


Determinants of P/E Ratio

Payout Ratio

Growth rate

Discount rate

Riskiness of the firm (Beta)


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Valuation

Relative Valuation


Investment strategies that relate P/E ratios with

expected growth rate P/E to growth ratio is used to measure the relative value, with

lower value compared to peers is associated with the

undervaluation.

There is no reason why a firm with lower P/E ratio with higher

expected growth is under valued. Lower P/E multiple could beindicator of higher risk or higher interest rates.


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Valuation

Relative Valuation

Price to Book Value Multiple

Hence,

P0 = RoE * BV0 * Payout Ratio * (1+g)/ (r-g)P0/ BV0 = RoE * Payout Ratio / (r-g). Assuming RoE is

based on expected earnings

Now, RoE * Payout = RoE g

Hence,

P0/ BV0 = (RoE- g)/ (r-g)

This implies if RoE exceeds the required rate of return (r),the price will exceed the book value and vice-a-versa.


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Valuation

Relative Valuation


Equation for a high growth firm

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

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


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Valuation

Relative Valuation


Relationship with RoE

RoE impacts the P/ Bv in two ways

Directly (it being the numerator the ratio)

Indirectly (it affecting the growth of the company

indirectly)

Example

When RoE = Required rate of return, r, the price is equal to

Book Value.


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Valuation Relative Valuation


Looking for undervalued securities

Generally, P/ Bv is positively related to the RoE

The point of interest could be the securities having a. higherRoE and lower P/ Bv b. lower RoEs and higher P/ Bv

Overvalued

Low RoE

Higher P/ Bv

Low RoE

Low P/Bv

High RoE

High P/ Bv

Undervalued

High RoE

Low P/Bv

RoE- r

P/Bv


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Valuation

Relative Valuation


Now, lets look at the determinants of RoE

To the extent that there is correlation between current RoE andfuture RoE, it is fair to use the historical data. However, when the

competitive environment is changing, focusing on current RoE

could be dangerous and can lead to significant errors in valuation.

The difference between the RoE and required rate of returns is

the measure of the firms capacity to earn supernormal profits in

the business it operates.

One of the frameworks that can be used to analyze the degree of

such supernormal profits can be given by Porters Five Force

Model.


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Valuation

Relative Valuation


Limitations

Book values are affected by accounting practices (like inearnings)

Book value may not carry much meaning for services firm that

does not have significant assets

A firm having sustained string of negative profits can lead to

negative P/ Bv ratio

Empowering People Transforming Businesses86


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Relative Valuation

Price to Sales Multiple

Disadvantage of Price to sales ratio

projecting financials & valuations

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