Chapter 10

10.1 Difference between Price and Value

Mr. Seth Klarman, a known value investor stated: "In capital markets, price is set by the most panicked seller; value, which is determined by cash flows and assets, is not. This is both the challenge and the opportunity of investing: to carefully sift through the markets to find the greatest divergence between price and value, and to concurrently avoid the extreme emotions of the crowd and, indeed, to take a stand against them."

Warren Buffett is also known to state frequently: "Price is what you pay and Value is what you get."

There is no formula or method to put to throw a precise number on valuation of an asset. There are uncertainties associated with the inputs that go into the valuation process. As a result, the final output can at best be considered an educated estimate, provided adequate due diligence associated with valuing the asset has been complied with. That is the reason, valuation is often considered an art as well as a science. It requires the combination of knowledge, experience and professional judgment in arriving at a fair valuation of any asset.

10.2 Why Valuations are required

While purpose of carrying out valuation could vary from person to person, some of the reasons for carrying out valuations of assets/businesses/liabilities are as follows:

• Buying a business as part of investment exercise
• Selling a business as part of investment exercise
• Mergers and Acquisitions
• General sense of value of business to owners
• Fair treatment to different set of stake holders in case of equity swap
• Accounting, taxation and other regulatory and legal requirements

Whatever may be the objective of valuation, the purpose of valuation is to relate price to value and estimate if it is fairly priced, over-priced or under-priced. Given the limitations in the valuation process, valuers typically present multiple scenarios that reflect the effect of a change in the primary variables on the output value.

10.3 Sources of Value in a Business – Earnings and Assets

Warren Buffett stated: "There are only two sources of value in a business - Earnings and Assets". Any asset, whether a financial asset such as a stock or a bond, or a real asset generates two streams of cash flows - periodic earnings and a final inflow on sale of the asset.

• In case of bonds, coupons produce earnings and redemption/sale of bond in the market produces one-time cash flow
• Equities also produce earnings in the form of dividends and then onetime cash flows on sale
• Real estate provides rental income and an appreciated capital value on sale

10.4 Approaches to valuation

Asset valuation can be broadly classified into three categories:

1. Cost based valuation

Under this approach, an asset is valued based on the cost that needs to be incurred to create it. This option is suitable only for a buyer who has choice between buying versus making. Most investors in the stock market typically do not have a choice to build and run a company on their own. Hence, this approach is generally not suitable for financial investors. However, strategic investors, who intend to carry on the business into the long term may consider using this approach.

2. Cash flow based valuation (intrinsic valuation)

Intrinsic valuation approach assigns value to an asset based on what an investor would be willing to pay for the cash flow generated by the assets. This approach typically involves valuing an asset by discounting its cash flow at a suitable rate that reflects the rate of return expected by an investor.

Intrinsic valuation can be divided into two categories:

• Risk neutral valuation: It involves adjusting the cash flows by the probability of realising the cash flow. It is then discounted at risk free rate. Insurance companies are typically valued using this approach (embedded value and appraisal value).
• Real world valuation: It involves estimating the most likely cash flow and discounting it at a rate of return that reflects the risk free rate plus a suitable risk premium to account for the uncertainty in the cash flows.

3. Selling price based approach (relative valuation)

Under this approach an asset is valued based on the price of other similar assets. Various valuation ratios such P/E, P/B, EV/EBITDA can be used as the valuation metric.

10.5 Discounted Cash Flows Model for Business Valuation

This is an example of discounted cash flows model for bond valuation. Actually, every asset or liability is priced the same way. Assets are acquired at a cost and the expectation is for these assets to generate a combination of earnings and/or capital gains (on sale of assets).

If the bond is replaced with equity, the coupons will be replaced with dividends and redemption value by expected sales proceeds from sale of equity. However, in case of bonds, both quantum of cash flows and their timings were known with certainty, in case of equity quantum of cash flows (dividends or sales price) and their timings are unknown and uncertain.

There are three different approaches to DCF models:

10.5.1 Dividend Discount Model (DDM)

Under this model, the expected future dividends of a company are discounted based on the cost of capital. This model is suitable for companies that pay regular and substantial dividend. Thus, this model is more suitable to matured companies in the defensive industry.

Unlike bonds, equities have perpetual life, theoretically. Further, dividend payments are not contractual in nature. Therefore, DDM involves making certain estimates and assumptions.

10.5.2 Free Cash Flow to Equity Model (FCFE)

One of the problems in using DDM is that it is not possible to use for companies that do not pay dividends. Even some of the well performing companies may not pay substantial dividend as they may want to use it for reinvestment. For instance, Alphabet Inc. (parent company of Google) has never paid dividend.

The FCFE model provides an alternative to dividends. Under this model, equity is valued by discounting the free cash flow to equity share holders instead of the actual dividends paid by the company.

Operating cash flow
(-) Capital expenditure
(-) Interest payments
(+/-) Net borrowings/(repayments)
= Free cash flow to equity
            

FCFE models are most likely to be useful for companies that are in "high growth" phase. However, if a company is in high growth phase, it would be inappropriate to assume a constant growth rate for the cash flows. The growth rate the company may be experiencing is likely to be very high (unsustainable in the long run) and may also be higher than the cost of capital.

In such cases, it would be appropriate to value the cash flows of the company in two stages:

10.5.3 Free Cash Flow to Firm Model (FCFF)

One of the major challenges in using the FCFE model is that, unless a company has an objective debt policy, it is not possible to objectively estimate the net borrowings / (repayment). If a company does not have a stated policy, the borrowings may have to be estimated using arbitrary considerations. This can lead to significant bias in valuation.

Thus, in many such cases, analysts prefer to use FCFF model. FCFF represents the free cash flow before taking into consideration any cash flows pertaining to any source of capital.

Operating cash flow
(-) Capital expenditure
(-) Tax benefit on Interest payments
= Free cash flow to firm
            

EBIT × (1 – Tax rate)
(+) Depreciation & Non-cash charges
(-) Increase in working capital
(-) Capital Expenditure
= Free cash flow to firm
            

Under the FCFF model, the value of the business (Enterprise value) is derived by discounting the FCFF. Since FCFF is the cash flow available to all sources of capital, discount rate is taken as the weighted average cost of capital (WACC) that factors all sources of capital and investors' expected return on the same.

Once the value of business is estimated, the value of equity is then derived by subtracting minority interest, preferred share capital and debt and by adding cash, cash equivalents and short term investment.

10.5.4 Cost of Capital

The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and therefore the expectations of the investors.

10.6 Relative valuation

As seen above, DCF method throws up a number on valuation based on stream of cash flows, their expected timings and a discount rate. It is a complicated method, given the assumptions which go into estimation of future cash flows.

Valuation exercise is undertaken to compare the price with value to arrive at whether a business is overpriced, under-priced or fairly priced by the market. This helps analysts make their recommendation – buy, sell or hold.

Instead of finding absolute valuation of business, we may like to compare 'what we get' with 'what we pay' to arrive at sense of valuation. What we pay is the price and what we get is the earnings and assets of the business. Therefore, if we can compare price with earnings and assets, we can get a sense of valuation – not the absolute valuation but whether something is cheap or expensive.

10.7 Earnings Based Valuation Matrices

10.7.1 Dividend Yield – Price to Dividend Ratio

Dividends are the profits that the company pays out to its equity holders. Well managed companies maintain a stable dividend payout to its investors even while ensuring that the growth prospects of the company are adequately funded, by ploughing back a portion of the profits.

If equity yields are in general higher than bond yields, clearly equity is available cheap. This is typically true when markets are down. On the other hand, during bull markets, equity yields are quite lower than the bond yields.

10.7.2 Earning Yield - Price to Earnings Ratio

When dividend yields are quite low, market analysts move to earning yields, a step higher to consider the investment potential in a stock.

EPS represent the net profit divided by number of shares. Generally, only a part of the EPS is distributed as dividend and part is retained by the company for future expansion.

The PE ratio indicates the amount of money an investor needs to invest to receive 1 unit of profit. It is calculated using the current market price and the historical EPS, or forward PE by using the forecasted EPS.

10.7.3 Growth Adjusted Price to Earnings Ratio (PEG Ratio)

As mentioned earlier, companies with high (low) growth rate should trade at a premium (discount) compared to their peers. However, determining the amount of premium is likely to be subjective. Growth adjusted price to earnings ratio (also called PEG Ratio) overcomes this problem by factoring in growth rate in its calculations.

PEG Ratio was the term coined by Peter Lynch, a savvy investor and fund manager. He believed that sometimes a high price to earnings ratios could be justified on the foundation of high growth potential in the business. However, he also warned that high growth regime may not continue for very long time and investors should be cautious of this fact. He stated that as long as PEG ratio is less than 1, business may be treated as undervalued.

10.7.4 Enterprise Value to EBIT(DA) Ratio

A business can be funded by various sources of capital including common equity, preferred share capital and debt. Since common equity has the residual interest (i.e. they are entitled for whatever is left after paying all others), the rate of return earned on equity would also be affected by the current capital structure of the business. Thus EPS, and in turn ratios such as PE or PEG ratio, are impacted by the capital structure of the business.

While a retail investor may not have major say on the capital structure of the company, a controlling shareholder can alter the capital structure. Thus, from an acquirer perspective a valuation ratio that is neutral to the capital structure is likely to be more suitable.

Thus, when a company is valued from the perspective of an acquirer or when it is a potential acquisition target, it would be more appropriate to value it based on Enterprise value/EBIT or Enterprise Value/EBITDA ratios.

Both the ratios are neutral to capital structure. However, in the case of capital-intensive industries, the difference in the historical cost of asset and choice of depreciation method can cause major discrepancy in the method of depreciation. Therefore, for such industries it is preferable to use EV/EBITDA. For other industries, EV/EBIT is preferable.

10.7.5 Enterprise Value (EV) to Sales Ratio

PE ratio, EV/EBITDA or EV/EBIT ratio cannot be applied if the underlying profit metric is negative (i.e. loss).

Further, in the case of companies that have recently managed to break-even, the profit is likely to be much lower than their long-term potential. In such cases, the above multiples would be too high to be meaningful.

In these cases, EV/Sales is likely to be a more meaningful metric as sales can never be negative. However, EV/Sales is suitable only in cases of companies that are likely to turn profitable and sustain such profitability in future.

10.8 Assets based Valuation Matrices

The previous section looked at the comparison between what is paid and what is received in terms of earnings. In this section, assets will replace earnings and focus on the balance sheet variables to identify value in the business.

Return on Equity (ROE) and Return on Capital Employed (ROCE) are two important ratios in investment:

ROE and ROCE indicate how well a business allocates its capital and what are the returns on the book values of equity and equity along with debt respectively. However, investors are looking at return on their invested capital today and not essentially return on book values.

10.8.1 Price to Book Value Ratio

Profit based valuation ratio such as PE or EV/EBIT(DA) focuses on how much an investor has to invest to earn a unit of profit. Price to book value ratio, on the other hand, focuses on how much an investor needs to invest to gain ownership interest.

This ratio measure how much an investor needs to invest to get ownership right per unit of net assets of the company.

The ratio is preferred more for valuing companies in financial sector than in other sectors. This is on account of the reliability of the book value numbers. Since most of the assets of financial companies are monetary assets, the book value of assets more closely reflects their fair values.

10.8.2 Enterprise Value (EV) to Capital Employed Ratio

10.8.3 Net Asset Value Approach

Net asset value (NAV) of equity is the market value of an entity's assets minus the value of its liabilities. This is different from the book value or net-worth of equity as one is using the market value of asset (not book value of assets) to arrive at the NAV.

Net asset value may represent the current value of the total equity, or it may be divided by the number of outstanding shares to compute net asset value per share. This valuation methodology is used in some businesses which are extremely assets oriented such as Real Estate, Shipping, Aviation etc.

10.8.4 Other metrics

In addition to the above, there are many valuation ratios that an analyst may employ depending upon the industry and the scenario. These include:

• Price/Embedded value: This metric is specifically used in the case of life insurance business. Embedded value refers to the present value of the expected net future cash flow (adjusted for probability) of a life insurer from the policies that are currently in force.
• Price/Adjusted book value: Adjusted book value (ABV) refers to fair value of asset minus fair value of its liabilities. As compared to book value, ABV factors in off balance sheet items as well. This metric can be applied to value NBFCs.
• EV/Capacity: In certain scenario, the financial metrics of a company many not reflect its potential value. This is likely in the case of start-ups or companies that are currently undergoing special situations. Under such scenario, it may be appropriate to use operating metrics in place of financial metrics. For example, a large steel plant currently out of operation can be valued based on its production capacity. A start-up in e-commerce can be valued based on the number of users, number of transactions or based on the value of transactions carried out in its website/mobile app.

10.9 Relative Valuations - Trading and Transaction Multiples

Relative valuation is basically intuitive. We do this all the time in our personal lives. Here, we try to value an asset looking at how the market prices similar/comparable assets. Best example of this is pricing real estate. If you are looking to buy an apartment, you always find the price of comparative apartments in that locality which kind of becomes your indicative value for negotiation purpose.

This is highly useful and quick estimate of value with limited computations and assumptions. However, it reflects current market mood, which may be quite optimistic or pessimistic. Therefore, it is always good to use parameters like maximum, minimum, average etc. while using relative valuations.

Practically, all the earnings and assets based valuation parameters defined above can be looked at for each business historically for several years. One can also look at these parameters as comparison across the peers and/or industry ratios to build a sense whether something looks cheap or expensive. These comparables may be coming from the Stock market (called Trading Multiples) or from the other similar transactions (called Transaction Multiples).

10.10 Sum-Of-The-Parts (SOTP) Valuation

Several businesses operate as a cluster/bundle of businesses rather than one business. For example, ITC, L&T and other corporations have different business under one umbrella. Best way to value these businesses is to value each business separately and then do the sum of those valuations. This method of valuing a company by parts and then adding them up is known as Sum-Of-Parts (SOP) valuation.

Please note for all practical purposes each of the business verticals for these conglomerates would be treated as an independent business and valued as described above in this unit based on earnings and assets. And, then simple summation can be used to arrive at the value of the total business.

10.11 Other Valuation Parameters in New Age Economy and Businesses

Sometimes, people wonder on valuations of the new age businesses such as Ecommerce companies or tech companies such as Whatsapp, Zomato, Linkedin, Facebook, etc. Honestly speaking, it is difficult to put the numbers together to arrive at the valuations at which these transactions are happening. We may call it our own limitation to understand the value proposition.

Without attempting to do this impossible task, let us state that in new age economy, people use absolutely new parameters/language such as eyeballs, page reviews, footfall, ARPU, no. of users etc. to justify exorbitant valuations.

10.12 Capital Asset Pricing Model

Capital Asset Pricing Model has been discussed earlier in this chapter in section 10.5.

10.13 Objectivity of Valuations

So many computations for valuation result in to a question "Is Valuation objective?"

This may appear so but it is a very subjective exercise as inputs required in various methods, as defined above, are quite subjective without any generally accepted standards. Further, Valuation is not timeless and it can change dramatically if circumstances of business change.

10.14 Some Important Considerations in the Context of Business Valuation

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