Lecture 1
24th August, 2009
By
Shobhit Aggarwal
Introduction to Valuation
Why value companies ?
Price is what you pay
Value is what you get
The basic purpose of valuation is to find
the right price to be paid/received
The purpose is not just to evaluate the
value of an asset but also the source of
this value
Why value companies ?
Every asset has a value
Although the techniques may differ but the
basic principles remain the same
Common sense says that you should not
pay more for an asset than it is worth
But “Bigger fool theory” prevails
Disagreements in valuation
What is the fair value for an asset?
How much time will market price take
to adjust to fair value?
Perspectives in Valuation
Share purchase/sell
Mergers and acquisitions
Private placements
Sell-offs
IPOs/Secondary Offerings
Rights issues
Biases in equity research
Strong buy bias
Information
Fund managers
IB divisions
Stay with the pack
Myths associated with valuation
Myth 1: Valuation is objective as the
valuation methods are quantitative
The biases and the purposes vary
Do not take decisions before valuation is
complete
Myths associated with valuation
Myth 2: A well-researched and well-done
valuation is timeless
New information changes value
Info could be firm-specific – business model
Info could be sector specific – government
regulations
Info could be economy wide - recession
Myths associated with valuation
Myth 3: A good valuation is a precise
estimate of value
Accuracy of assumptions made in a valuation
dictate the final accuracy of the valuation
The business life-cycle, the economic
situation, the country/countries of operation,
the number of separate business lines all add
to uncertainties in the assumptions
The benefits to valuation are greatest where
difficulties are more
Myths associated with valuation
Myth 4: The more quantitative a model,
the better the valuation
As models become more complex, they need
more inputs – hence more prone to errors
In fact, more complex models become difficult
when the analyst who made them is no longer
there
Myths associated with valuation
Myth 5: To make money using valuation,
you have to assume that markets are
inefficient
Markets are efficient because people are
continuously trying to find stocks that are
under-valued or over-valued
Implicit is the assumption that markets will
correct after you take positions
Myths associated with valuation
Myth 6: The value you find is important,
the process to arrive at it is not
The process of valuation can tell us the weak
points and the sources of value. This allows
us to see :-
How sustainable is the value we found?
What to change to improve valuations?
Role of valuation
Fundamental analysts
The investment rationale is valuation
Technical analysts
To develop support and resistance levels
Information traders
For the relationship between information and value
Market timers
Evaluating whether market is under-valued or over-
valued
Efficient marketers
To find out the implicit assumptions of growth and
risk in the market
Role of valuation – Investments
Fundamental analysts
The investment rationale is valuation
Technical analysts
To develop support and resistance levels
Information traders
For the relationship between information and value
Market timers
Evaluating whether market is under-valued or over-
valued
Efficient marketers
To find out the implicit assumptions of growth and
risk in the market
Role of valuation – Acquisitions
Value from acquirer’s perspective
Value from target’s perspective
Value of synergy
Value of changing management
Value of restructuring
Concept Checker
Value of an asset depends on the demand
and supply in the market
Value is determined by investor
perceptions about the asset
Value of an asset depends on the
methodology or the model used
Value of an asset will depend upon the
assumptions used in a model
Approaches to valuation
Discounted cash flow
The value of an asset is the present value of
its future expected cash flows
Relative valuation
The value of an asset is estimated using
pricing of comparable assets
Contingent claim valuation
Option pricing methods to value assets
having option like characteristics
Relative Valuation
Law of one price
Similar assets should trade at the same price in the
market
Comparison to other peers (Cross-sectional
analysis)
Assumption that all firms except the one under
valuation are fairly valued
Comparison to past ratios (Time series
analysis)
Assumes that fundamentals have not changes and
that the company was fairly valued in the past
DCF
DCF tries to estimate intrinsic value of an
asset
Intrinsic value is the value that an all-knowing
analyst will estimate
Three paths to DCF valuation
Value equity (DDM, FCFE, Residual Value,
VC)
Value the firm as a whole (FCFF)
Valuation in parts (APV)
When DCF runs into trouble
Sick firms
Cyclical firms
Firms with unutilized (or underutilized)
assets
Firms with patents
Firms undergoing restructuring
Firms involved in acquisitions
Private firms
Pitfalls in relative valuation and DCF
Relative valuation
Analyst chooses the comparables and does
can justify his biases
The under/over-valuation of a market as a
whole is overlooked
DCF
The analyst makes the assumptions about
cash flows, risk and growth and can thus
justify his biases
Valuation Methodologies - Summary
Relative Valuation
DCF
Valuing equity
Dividend Discount Model
FCFE
Residual Value
Venture Capital Method
Valuing firm
FCFF
Valuation in parts
APV
Real Options
Reading Financial Statements
Principal components of Balance Sheet
Assets
Economic resources that are likely to produce future
economic benefits are can be measured with a
reasonable degree of certainty
Liabilities
Economic obligations that are likely to produce
future economic costs and can be measured with a
reasonable degree of certainty
Equity
The difference between Assets and Liabilities
Sample Balance Sheet
Current assets
Cash and cash equivalents 500
Accounts receivable 1200
Inventory 800
Long term assets
Property Plant and Equipment 1700
Total assets 4200
Sample Balance Sheet
Current liabilities
Accounts payable 600
Short-term debt 1000
Current portion of long-term debt 200
Long term liabilities
Long term debt 1500
Total liabilities 3300
Share Capital 100
Retained Earnings 800
Total equity 900
Total liabilities and equity 4200
Principal components of Income Statement
Revenues
Economic resources generated in a particular
time period. Revenues should be recognized
when
The firm has provided all or almost all goods
and/or services to the customer
The customer has paid cash or is expected to
pay cash with a reasonable degree of certainty
Principal components of Income Statement
Expenses
Economic resources used up in a time period.
Expenses are recognized by matching and prudence
principles. They should be recognized when
They are costs directly associated with revenues
recognized in the same period
They are costs associated with benefits that are
consumed in this time period
They are resources whose future benefits are not
reasonably certain
Profits
They are the difference between revenues and
expenses
Sample Income statement
Revenues 1900
Cost of goods sold (700)
Gross profit 1200
Selling, general and admin expenses (300)
Other expenses (150)
EBITDA 750
Depreciation and amortization (150)
EBIT 600
Interest (100)
Earnings before Tax 500
Tax (150)
Net Income 350
Sample Cash Flow Statement
Cash Flow from operations 500
Investing Cash Flow (300)
Financing Cash Flow 100
Net change in cash 300
Opening cash 200
Closing cash 500
Accounting Analysis
What is accounting analysis?
Accounting analysis is the process which
evaluates the degree to which a company’s
accounting captures its economic reality
Accounting flexibility and management
discretion together cause the accounting
numbers to be different from underlying
economics
The analyst has to know how to restate the
accounting numbers to undo the effects of
accounting distortions and bring them closer to
economic realities
What makes accounting data unreliable?
Rigidity of accounting rules
E.g. All R&D must be expensed in some
countries
Random forecast errors
E.g. credit defaults
Management discretion
Why would management distort numbers?
Debt covenants
Management compensation
Tax considerations
Corporate control
Regulatory considerations
E.g. anti-trust, import tariff, quotas
Capital market considerations
Stakeholder considerations
E.g. labor unions
Competitive considerations
Doing Accounting analysis
Step 1: Identify key accounting policies
E.g. forecasts of credit card defaults,
forecasts of residual values in leasing
business
Step 2: Assess accounting flexibility
Does the firm have flexibility in its key
success factors?
E.g. Default rates in banking, R&D in bio-tech
firms
Doing Accounting analysis
Step 3: Evaluate Accounting Strategy
Compare policies to peers
E.g. Is a lower default rate due to better risk controls or
aggressive assumptions?
Are the incentives to distort reality strong?
Has the company changed any policy? What is the
justification? What is the impact?
Has the company’s policies been realistic in the past?
E.g. Huge write-offs on goodwill, last quarter adjustments
Are some business transactions inspired from accounting
benefits?
E.g. Leases
Doing Accounting analysis
Step 4: Evaluate the quality of disclosure
Does the company give enough disclosures to assess
the firm’s strategy?
Do the footnotes explain the accounting policies and their
logic?
E.g. differences in revenue policies
Does the firm adequately explain its current
performance?
E.g. profit margins going down is visible in statements but is it
because of cost pressures or competition?
If accounting policies restrict freedom, does the M,D&A
give pointers to the effects?
E.g. Training expenses that were not allowed to be included as
assets
Doing Accounting analysis
Step 4: Evaluate the quality of disclosure
What is the quality of segment disclosure?
E.g. Does it give only revenue break-up or only
net profit break-up.
E.g. Are there significant inter-segment effects?
Is the management forthcoming with bad
news?
Does it give reasons for poor performance?
How strong is the investor relations program?
Is the management accessible to analysts?
Doing Accounting analysis
Step 5: Identify potential red flags
Unexplained changes in accounting policies,
especially when performance is poor
Unexplained transactions that boost profits
Unusual increases in account receivables compared
to sales
Relaxing credit policies or hastening this year’s
sales by loading distribution channels
Unusual increases in inventory compared to sales
Is the inventory build-up for finished goods, WIP or
raw materials?
Doing Accounting analysis
Step 5: Identify potential red flags
Is the gap between net income and cash flow from
operations increasing?
Is the gap between its reported income and tax
income increasing?
Does the company use financing mechanisms like
sale of AR with recourse?
Unexpected large asset write-offs
Large fourth quarter adjustments
Qualified audit opinions or changes in auditors
Related party transactions
Doing Accounting analysis
Step 6: Undo accounting distortions
The cash flow statement and the financial
statement footnotes can help the analyst in
removing the effects of accounting distortions
Accounting analysis pitfalls
Conservative accounting is not necessary good
accounting from an analyst’s perspective
Income smoothing can be a reason for conservative
accounting
Do not confuse unusual accounting with
questionable accounting
Different strategies may require different accounting
Not all changes in accounting policies are
earning management
Thank You
