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Institute of FINANCIAL ANALYSIS AND Institute of FINE005

IMT Management Technology BUSINESS VALUATION IMT Management Technology
Centre for Distance Learning, Ghaziabad IMT Centre for Distance Learning, Ghaziabad

FINE005
FINANCIAL ANALYSIS AND BUSINESS VALUATION

FINANCIAL ANALYSIS AND

ISBN:978-81-960482-5-9
Published by: Institute of Management Technology,
Edition-I

Centre for Distance Learning, Ghaziabad

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 Institute of
Management Technology
Centre for Distance Learning, Ghaziabad

VISION

Imparting continuum of management education through distance mode to learners across

the globe.

MISSION
Be an academic community leveraging technology as a bridge to innovation and life-long
learning.
To continuously evolve management competencies for enhanced employability and
entrepreneurship.
To serve society through excellence and leadership in management education, research and
consultancy.
EXPERT COMMITTEE

Prof. (Dr.) Vishal Talwar Prof. (Dr.) S. S. Yadav

IMT, Ghaziabad DMS, IIT Delhi

Prof. (Dr.) A.H. Kalro (Retd.) Prof. (Dr.) Madhu Vij (Retd.)
IIM, Kozhikode FMS, Delhi

Prof. (Dr.) P.K. Jain Mr. Ritesh Chandra

IT, Delhi Yes Bank, Delhi

Prof. (Dr.) B.B. Chakrabarti (Retd.) Prof. (Dr.) Ashok Sharma

IIM, Kolkata IMT CDL, Ghaziabad

Prof. (Dr.) Subhajit Bhattacharyya

IMT, Ghaziabad

SLM PREPARATION TEAM

Dr. Priti Sharma Ms. Arshiya Farooqui

IMT CDL, Ghaziabad Jamia Hamdard, Delhi

Dr. Kanhaiya Singh Ms. Rachna Gupta

Fore School of Management, Delhi Ramanujan College, Delhi

Dr. Vardah Saghir Dr. Priya Gupta

Jamia Hamdard, Delhi Jawaharlal Nehru University, Delhi

Ms. Ayesha Shaikh

Jamia Hamdard, Delhi

COURSE COORDINATOR EXPERT REVIEW

Dr. Priti Sharma Dr. Sandeep Goel

IMT CDL, Ghaziabad Professor, Accounting, Finance and Corporate
Governance
MDI, Gurgaon

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© Institute of Management Technology, Centre for Distance Learning, Ghaziabad
ISBN: 978-81-960482-5-9
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ACKNOWLEDGEMENT

We acknowledge, with gratitude, the assistance taken, in preparing the study

material of the present course, from the texts, websites, and a/v sources
cited at different places within the Units. We, thankfully, also acknowledge
the assistance taken by us from the content generated by individual authors,
publishing houses, educational institutes, research agencies, consultancies,
government bodies and public sources of commercial organizations etc.
(cited within the Units).
 Institute of FINE005
Management Technology
Centre for Distance Learning, Ghaziabad
Financial Analysis and
Business Valuation

INDEX

UNIT 1
Understanding Financial Statements 1
UNIT 2
Financial Statements Analysis 43
UNIT 3
Cash Flow Statement 89
UNIT 4
Valuation 117
UNIT 5
Economic Analysis 145
UNIT 6
Industry Analysis 165
UNIT 7
Company Analysis 191
UNIT 8
Forecasting of Cash Flows-I 213
UNIT 9
Forecasting of Cash Flows-II 233
UNIT 10
Discounting Rate 255
UNIT 11
Business Valuation – DCF Model I 283
UNIT 12
Business Valuation – DCF Model II 303
UNIT 13
Relative Valuation 321
 COURSE OVERVIEW: FINANCIAL ANALYSIS AND BUSINESS VALUATION
This course equips you with the tools and techniques to analyse financial statements, assess
fundamentals and apply valuation models to arrive at the intrinsic worth of a business or stock.
The course begins with financial statement analysis and then exposes the learners to growth estimation,
analysis of fundamentals, cashflow forecasting, and application of various approaches to valuation.
The course offers an engaging learning experience with judicious combination of sound theoretical
concepts and application of same with the help of real-life examples and case studies. The sound
understanding of the financial statement analysis and valuation models is quite important for a finance
professional specifically those who are working in domain of Equity Analysis& Portfolio Management,
Mergers & Acquisitions, Credit Evaluation, Investment Banking, Corporate Finance, Fund Manager etc.
and for an avid investor. The course content is divided in thirteen units as follows:

Unit 1: Understanding Financial Statements

This unit covers the Financial Reporting format of Balance Sheet and Statement of Profit & Loss as per
Companies Act 2013, Schedule III. This is followed by detailed explanation of various components like
Assets, Liabilities, Equity, Revenue, Expenses, Depreciation, Profit and EPS etc. This is illustrated using
Real life example of Balance Sheet and Statement of Profit & Loss for select companies.

Unit 2: Financial Statements Analysis

Analysis of Financial Statement with the help of ratio analysis technique is quite important for
analysis of soundness of business, for all the stakeholders, for sound decision making. Analysis of
liquidity, solvency, efficiency, and profitability is extremely important for a business analyst and
finance manager. The relevant ratios and their interpretations are explained in with the help of
suitable examples in this unit.

Unit 3: Cash Flow Statement

Cash is considered as lifeline of a business and cashflows are tangible proof of income of a business.
Profits are calculated on accrual basis and may not depict true financial condition and payment capacity
of a business. Therefore, it is important to analyse flow of cash, its sources and usage in a business.
This unit explains the meaning and importance of cash flows, preparation of cashflow statement from
operations, investments and financing activities is explained with the help of suitable examples.

Unit 4: Valuation

This unit explains the meaning, importance, and approaches to valuation. To take the decision whether
to invest or liquidate an investment it is important to assess its true worth. There are various method
or approaches to valuation like Asset based Valuation, Replacement Valuation, Liquidation Valuation,
Discounted Cashflow Valuation and Relative Valuation etc. This unit introduces the learner to various
valuation methods and their applicability.

Unit 5: Economic Analysis

True worth of an investment is driven by its fundamentals. For valuation of a business its important to
assess the macro as well as micro factors affecting its performance. Fundamental Analysis include the
analysis of Economy, Industry and Company. This unit covers the economic cycle and various economic
indicators, their meaning, and implications. Thorough understanding of these indicators helps you to
understand the prospects of economy and selection of sectors/industries for investment purpose in
view of economic indicators.
Unit 6: Industry Analysis

Analysis of industry in which a business is operating is extremely important to assess the micro
factors influencing the performance of business. The analysis of industry includes study of industry
life cycle, assessment of outlook and growth prospects of sector, Porter’s five forces analysis to
investigate the influence of buyer& supplier industry, threats of substitute products and competitive
forces that affects a business. This unit explains various types of industries, the analysis of growth
drivers and assessment of outlook for the industry with the help of suitable examples.

Unit 7: Company Analysis

Analysis of a business include the study of company performance, important ratios, management
team, analysis of business risk and financial risk. This unit describes various types of business risk
like operational risk, regulatory risk, industry specific risk in an engaging manner. Various ratios are
utilised to analyse the solvency and financial risk of the business. Unit also covers the SWOT analysis
technique to find out strengths & opportunities and investigate the weakness and challenges of a
business.

Unit 8: Forecasting of Cash Flows-I

This unit explains the importance of growth forecasting for the purpose of forecasting of cashflows.
A business may experience normal growth or supernormal growth depending on various factors
driving the growth. The growth drivers and estimation of growth is discussed and how it influences the
cashflow forecasting is the subject of discussion in this unit.

Unit 9: Forecasting of Cash Flows-II

This unit discusses that high growth businesses leverage on certain factors that leads to competitive
advantage. The length of supernormal growth period depends on the length of competitive advantage.
The forecasting of cashflows after incorporating the projections of competitive advantage period
and normal growth rate after completion of competitive advantage are elaborated with the help of
illustrations.

Unit 10: Discounting Rate

This unit explains the concept of risk, and required return of various sources of capital are discussed.
Concept of beta and its usage in analysing the sensitivity of a security’s return to market are explained.
Discount rate applicable for discounting of cashflows from an asset is dependent on riskiness of
cashflows. Cost of capital of different investments is to be applied as discounting rate. This unit discusses
the cost of debt, cost of equity and weighted average cost of capital to be applied as discounting rate
on relevant cashflows generated from them.

Unit 11: Business Valuation – DCF Model I

This unit explains the Free Cash flows to Equity (FCFE) and Free Cash Flows to Firm (FCFF) for valuation
of Equity and a business respectively. Discounted cash flow models based on types of cashflows are
discussed. Single stage cash flow model is applicable to firms growing at normal growth rate. For a firm
growing at supernormal growth rate, two stage or multi-stage cash flow model shall be applicable.
The single stage cashflow valuation model is illustrated in this unit for valuation of equity with FCFE and
valuation of a firm with FCFF model.

Unit 12: Business Valuation – DCF Model II

Valuation of a firm with a competitive advantage period is to be done using two-stage and multi-stage
discounted cash flow valuation model. These models require estimation of growth rate, discount rate
etc. to input the parameters in DCF valuation model and quantitative analyses based on these inputs
results into assessment of intrinsic value of the asset or business. The application of two-stage model
and valuation using sensitivity analysis to analyse the impact of different scenarios on the business
valuation is discussed in this unit.

Unit 13: Relative Valuation

Relative valuation is the valuation approach in which worth of an Asset is calculated using the
comparable multiples of peers. For this purpose, earning multiples like Price-Earning Multiple,
Enterprise Value to EBITDA are used. Other important multiples like Price to Book Value, Price to Sales
etc is also used. This unit explains the rationale behind relative valuation models and application of
these multiple of peer companies to arrive at the valuation of a business.

In essence this course offers an enriching and engaging learning experience in equity analysis and
business valuation to the finance professionals and enthusiastic investors and learners.
 UNIT 1
UNDERSTANDING FINANCIAL
STATEMENTS

STRUCTURE
1.0 Objectives
1.1 Introduction
1.2 Objectives of Financial Statements
1.3 Who is interested in Financial Statement Analysis?
1.4 Balance Sheet
1.5 Income Statement
1.6 Statement of Cashflows
1.7 Statement of Changes in Equity
1.8 Changes in Debt
1.9 Quality of Financial Statements
1.10 Tools of Analysis of Financial Statements
1.11 Let Us Sum Up
1.12 Keywords
1.13 References and Suggested Additional Reading
1.14 Self-Assessment Questions
1.15 Check Your Progress – Possible Answers
1.16 Answers to Self-Assessment Questions

1.0 OBJECTIVES
After reading this unit, you will be able to:
1. explain the relevance of financial statements for various users.
2. identify the types of financial statements used in firms.
3. comprehend the concept, nature, and relevance of financial statements and
their analysis in the modern corporate world.
4. recognize the items in the financial statements.
1
5. analyze comparative and common size financial statements.
UNIT 1
Understanding Financial
Statements
NOTES 1.1 INTRODUCTION
In financial accounting, we learned about the three golden accounting rules and how to
record business transactions in the accounting books and then post them into the ledger.
We also learned how accountants balance multiple accounts and identify the accounting
mistakes by preparing trial balance. The primary purpose of accounting was to ascertain
the business’s financial performance (profit or loss) from the annual business operations.
For this, certain financial statements are prepared to know how much a business has
earned or lost for a particular period. The most common financial statements used for
this purpose are:
(i) The income statement (Profit & Loss account), and
(ii) The Balance Sheet (also known as the position statement).

This chapter deals with the types of financial statements companies prepare annually to
see the business’s profitability and financial position. Financial statements are generally
prepared at the end of a financial year, but as per requirements, they can be prepared
monthly or quarterly. These statements are widely used by Investors, bankers, or lenders
to know business’s financial health and earning potential. They are the snapshot of a
company’s finances and provide crucial information about its performance. Thus, financial
statements contain financial information about a business enterprise. The financial
statements include at least two critical statements that an accountant prepares at the
end of a financial year:
(i) The balance sheet
(ii) The income statement or the Statement of Profit and Loss.

These statements provide the accounting and financial information that the users can use
for decision making. They may analyze the available information to compare alternatives
and make informed decisions. The primary goal of financial statement analysis is to assess
the company’s historical performance in terms of liquidity, profitability, operational
effectiveness, and growth potential. The process of evaluating and analyzing the present
financial status and historical performance of certain investment decision-making criteria
is included in the analysis of financial statements. As a result, financial statement analysis
is crucial for planning future performance as well as evaluating past performance and
predicting.

1.2 OBJECTIVES OF FINANCIAL STATEMENTS

The main reason for preparing financial statements is to know the state of a company’s
finances as well as its earnings or losses over a specified period. There are two categories
for financial statements:
(a) position statements, which contain the balance sheet, and
(b) income statements, which include the trading account and the profit and loss
account.
The objectives of preparing financial statements are as follows:
1. Calculating the results of business operations: Any businessman is interested in
2
knowing the profits or losses that the company has made over a given period
 FINE005
Financial Analysis and
Business Valuation
as a result of its business operations. Using an income statement is how this is NOTES
achieved. Businesses can use the information to help them decide on various
matters, for e.g.: which products to keep and which to discontinue.
2. Assessing the financial status: Financial statements represent the position of a
company’s finances on a particular date. The position information consists of
the assets and liabilities the company has on a particular date. For this reason, a
position statement—a balance sheet—is created.
3. Information source: One important place to find out about a business unit’s
finances is through its financial statements. It supports the finance manager
in organizing the company’s financial operations, allocating funds wisely for
reserves and surplus, and paying out dividends to shareholders.
4. Supports managerial decision-making: By comparing the performance of the
current year to that of previous years, the Manager can undertake a comparative
analysis of the company’s profitability and make the necessary managerial
decisions.
5. A gauge of the business’s solvency: Both the short-term and long-term
solvency of an enterprise can be arrived using information from the financial
statements. This information helps the company to plan its credit transactions
like credit purchases, and sales, borrow money from banks and other financial
institutions.

1.3 WHO IS INTERESTED IN FINANCIAL STATEMENT ANALYSIS?

A financial statement analysis is the process of utilizing the right methods to analyze the
financial data from the balance sheet and profit and loss account of a business. Analysis
of financial statements helps various parties get the information they need to know about
the company. Financial statement analysis is of relevance to the following groups and
stakeholders:
Figure 1.1: Various Stakeholders of Financial Statements

Shareholders

Government Investors &

Bodies Lenders
Stakeholders
of Financial
Statements

Management Creditors

3
UNIT 1
Understanding Financial
Statements
NOTES The following table shows the list of stakeholders and their reasons of interest.
Table 1.1: Stakeholders and Reasons for Taking Interest

S. No. Stakeholders Reasons for Taking Interest

1. Shareholders They are concerned with knowing whether the company is
financially moving ahead or not.
2. Investors and They want to ensure that the company’s solvency position is
Lenders maintained all through.
3. Creditors They would like to keep checking that the company can settle
(usually short-term) obligations on the due date.
4. Management It is interested in knowing that the financial position of the
company is satisfactory so that they can plan for the growth
of the company.
5. Government Bodies like the Income Tax and GST1 departments would like to
Bodies ensure that the company is paying its taxes honestly and properly.

As a result, financial statement analysis entails looking at both the long-term trends in financial
statement figures as well as the linkages between them. The objective of preparing financial
statement analysis is to forecast a company’s performance based on its historical results.
Analyzing a company’s performance to pinpoint
issue areas is another goal. In summary, Components of Financial statement
financial statement analysis serves as both 1. Balance sheet: An instantaneous
forecasting tool for understanding a company’s picture of the financial health of a
future performance, and a diagnosis, or firm. It displays the details of the
determining where a company has problems. assets and obligations. When valuing
Further, there are various methods and a firm, balance sheet analysis is
techniques for financial analysis. One of the frequently the starting point.
tool is Ratio analysis. Comparing financial 2. Income statement: it is also referred
ratios with historical data and with those to as a profit and loss statement,
of other companies in the same industry this report details the income and
significantly increases their informativeness. expenses of the company. Expenses
The major financial statements that are are deducted from revenues to
generally prepared by Sole Proprietorship, determine the company’s net
Partnership Organizations and are mandatory income, or profit or loss.
for listed companies are:- 3. Cash flow statement: It keeps track
1. The Balance Sheet of cash, which might only represent
a portion of the revenue, as well as
2. Income Statement/Profit and Loss
sums received from investors and
Statement
lenders.
3. The Statement of Cash Flows

1.4 BALANCE SHEET

The items in the Balance Sheet may be slightly different for a Sole Proprietor, Partnership
and Limited Companies. The limited companies are required to prepare the balance Sheet
exactly in the format as prescribed by the Company Law Board.
4
1
GST is an indirect tax termed as Goods and Services Tax
 FINE005
Financial Analysis and
Business Valuation
1.4.1 F ORMAT 1 – THE T OR ACCOUNT FORMAT – NOTES
TRADITIONAL FORMAT
Under the traditional format, the left hand side of the balance sheet represents the
equity and liabilities while all assets viz. current assets, fixed assets are shown in the
right hand side. This format is generally used by small business entities. This is also
called as horizontal balance sheet. We present the format of this balance sheet as
follows;

1.4.1.1 HORIZONTAL BALANCE SHEET

Table 1.2: Horizontal Format of Balance Sheet

1.4.2 FORMAT 2 – THE REPORT FORMAT

In the Report Format, assets are presented at the top, followed by liabilities and equity.
This format is more common in larger businesses and is often preferred for its simplicity.
The assets are listed first, followed by liabilities and equity. This format provides a clear
view of the company’s total assets, total liabilities, and total equity.

1.4.3 FORMAT 3
Companies are required to produce and report their final accounts in accordance with
Schedule III of the Company Act, 2013. The Schedule was created to align with evolving
5
economic views that promote privatization, globalization, and the resulting changes
UNIT 1
Understanding Financial
Statements
NOTES in corporate financial reporting procedures. The various additional characteristics of
Schedule III are as follows-
• The balance sheet elements are shown in a vertical manner, with their division into
current and non-current categories.
• A profit and loss statement presented in a vertical manner, categorizing costs
according to their kind.
• The idea of “Schedules” has been eliminated and the relevant information is now
provided in the “Notes to accounts”.
• The document lacks explicit information on the items listed in Schedule VI under
the category of “Miscellaneous Expenditure.”
• The negative value of the profit and loss statement’s debit balance will be presented
under the “Reserves and Surplus” category.
Preparation of cash flow statement in accordance with Accounting Standard 3
(AS-3).
The Schedule prioritizes AS in the event of any disagreement between AS and
Schedule.

1.4.4 BALANCE SHEET–PART 1 OF SCHEDULE III

• Assets are the resources that a company has control over as a result of previous
events, and are expected to generate future economic advantages for the company.
• Liabilities are the financial obligations of a company that result from previous
events and require the company to use its resources to settle them, resulting in a
decrease in its assets.
• Equity, on the other hand, represents the remaining ownership stake in a company
after subtracting all its liabilities.
Table 1.3: Balance Sheet Showing Equity and Liabilities

Particulars Note Figures as at the Figures as at

No. end of current the end of
reporting the previous
period period
1 2 3 4
I. EQUITY AND LIABILITIES
(1) Shareholder’s funds
(a) Share capital
(b) Reserves and surplus
(c) Money received against share
warrants
(2) S hare application money pending
allotment
(3) Non-current liabilities
(a) Long-term borrowings
6 (b) Deferred tax liabilities (net)

(Continues)
 FINE005
Financial Analysis and
Business Valuation
Table 1.3: Balance Sheet Showing Equity and Liabilities (Continued)
NOTES
Particulars Note Figures as at the Figures as at
No. end of current the end of
reporting the previous
period period
1 2 3 4
(c) Other Long-term liabilities
(d) Long-term provisions
(4) Current liabilities
(a) Short-term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
TOTAL
II. ASSETS
(1) Non-current assets
(a) Fixed Assets
(i) Tangible assets
(ii) Intangible assets
(iii) Capital work-in progress
(iv) Intangible assets under
development
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long-term loans and advances
(e) Other non-current assets
(2) Current assets
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and advances
(f) Other current assets
The Notes to Accounts will provide explanations for some items.

A. SHARE CAPITAL
For each class of share capital following points are to be kept in mind:
(i) Number and amount of shares authorized.
(ii) Number of shares which are issued subscribed and fully paid and which are
issued, subscribed but not fully paid.
(iii) Par value per share.
7
(iv) Shares outstanding at the beginning and at the end of the reporting period
should be reconciled.
UNIT 1
Understanding Financial
Statements
NOTES (v) Calls unpaid.
(vi) Forfeited shares.

B. RESERVES AND SURPLUS

Reserves and surplus can be distributed among the following sub-heads:
(i) Capital reserves
(ii) Capital redemption reserves
(iii) Securities Premium
(iv) Debenture Redemption reserve
(v) Revaluation reserve
(vi) Surplus; the balance as per profit and loss statement
(vii) Other reserves (specify the nature and purpose)

C. LONG TERM BORROWINGS

Long term borrowings can be classified under the following sub-heads:
(i) Bonds/Debentures
(ii) Term loans
(iii) Deferred payment liabilities
(iv) Deposits
(v) Long term maturities of finance lease obligations
(vi) Loans and advances from related parties
(vii) Other loans and advances (specify nature)

D. LONG TERM PROVISIONS

These can be classified as follows:
(i) Employee benefits provision like gratuity, provident fund etc.
(ii) Other provisions (specify the nature)

E. SHORT TERM BORROWINGS

Short term borrowings can be classified among the following sub-heads:
(i) Loans repayable on demand
(ii) Loans and advances from related parties
(iii) Deposits
(iv) Other loans and advances (specify the nature)

F. OTHER CURRENT LIABILITIES

Some of the other current liabilities can be grouped asunder:
8 (i) Interest accrued but not/and due on borrowings
(ii) Income received in advance
 FINE005
Financial Analysis and
Business Valuation
(iii) Unpaid dividends NOTES
(iv) Application money received for allotment of securities and due for refund and
interest accrued hereon
(v) Other current liabilities (specify the nature)

G. TANGIBLE ASSETS
Tangible assets can be classified as follows:
(i) Land
(ii) Buildings
(iii) Plant and Equipment
(iv) Furniture and Fixtures
(v) Vehicles
(vi) Office equipment
(vii) Others (specify the nature)
A detailed report showing additions, disposals, acquisitions through business combinations
and other adjustments and amounts related to depreciation, impairment losses, revaluation
etc., should be provided for each class of asset.

H. INTANGIBLE ASSETS
Intangible assets can be classified as follows:
(i) Goodwill
(ii) Brands/trademarks
(iii) Computer software
(iv) Mining rights
(v) Publishing titles
(vi) Copyrights, patents and other intellectual property rights, services and operating rights
(vii) License and franchise
(viii) Recipes, models, designs, formulae and prototypes
(ix) Others (specify the nature)
A detailed report showing additions, disposals, acquisitions through business combinations
and other adjustments and amounts related to depreciation, impairment losses, revaluation
etc., should be provided for each class of asset.

I. NON-CURRENT INVESTMENTS
Investments can be classified as under:
(i) Investments in property
(ii) Investments in equity instruments
(iii) Investments in preference shares
(iv) Investments in governments or trust securities
9
(v) Investments in debentures or bonds
UNIT 1
Understanding Financial
Statements
NOTES (vi) Investments in mutual funds
(vii) Investments in partnership firms
(viii) Other non-current investments (specify the nature)

J. LONG TERM LOANS AND ADVANCES

It can be classified under the following sub-groups:
(i) Capital advances
(ii) Security deposits
(iii) Loans and advances to related parties
(iv) Other loans and advances (specify nature)
The above shall also be sub-classified as follows:
(i) Secured, considered goods
(ii) Unsecured, considered goods
(iii) Doubtful

K. CURRENT INVESTMENTS
It can be classified as follows:
(i) Investments in equity instruments
(ii) Investments in preference shares
(iii) Investments in government or trust securities
(iv) Investments in bonds or debentures
(v) Investments in mutual funds
(vi) Investments in partnership firms
(vii) Other investments (specify the nature)

L. INVENTORIES
Inventories can be classified as:
(i) Raw materials
(ii) Work-in-progress
(iii) Stores and spares
(iv) Finished goods
(v) Loose tools
(vi) Stock in trade
(vii) Goods in transit
(viii) Others (specify the nature)

M. CASH AND CASH EQUIVALENTS

The following head can be classified as follows:
10 (i) Balances with banks
(ii) Cheques, drafts in hand
 FINE005
Financial Analysis and
Business Valuation
(iii) Cash in hand NOTES
(iv) Others (specify the nature)
The following are common items in Balance Sheet

ASSETS
Assets comprises of valuable resources owned or controlled by a company which have an
economic value. They comprises of physical items such as cash, inventory, and property, as
well as intangible assets like patents or intellectual property. We can understand different
types of assets through the following explanation.
• Current Assets: These are assets that are expected to be converted into cash or
used up within one year. Examples include cash, accounts receivable, and inventory.
• Fixed Assets (or Non-Current Assets): These are long-term assets with a useful
life of more than one year. Examples include property, plant, equipment, and
intangible assets like patents and trademarks.
• Cash and Cash Equivalents: This includes physical currency, bank balances, and
short-term investments that are easily convertible to cash.
• Accounts Receivable: The money owed to the company by its customers for goods
or services sold on credit.
• Inventory: The goods a company holds for the purpose of resale.

LIABILITIES
Liabilities in the Balance sheet represent the financial obligations or debts that a company
owes to external parties. The liabilities arise on account of transactions the company
make to meet allocation of resources or to meet other obligations.
• Current Liabilities: Obligations that are expected to be settled within one year.
Examples include accounts payable, short-term loans, and accrued expenses.
• Long-Term Liabilities: Debts and other financial obligations that will not become
due within the next year. Examples include long-term loans and bonds.
• Accounts Payable: Amounts owed by the company to its suppliers or vendors for
goods and services received on credit.
• Accrued Liabilities: Liabilities that have been incurred but not yet paid. Examples
include accrued salaries and accrued interest.

EQUITY
• Owner’s Equity (or Shareholders’ Equity): Represents the owners’ residual interest
in the assets of the company after deducting liabilities. It is the net worth of the
company and includes common stock, retained earnings, and additional paid-in
capital. It can be calculated by the difference between an organization’s assets
and liabilities for a particular period. Assets = Liabilities + Equity is also called as
accounting equation.
• Retained Earnings: The cumulative amount of profits that have been retained in
the business rather than distributed to shareholders as dividends.
• Common Stock: It represents the ownership interest in a company as the common 11
stock (also known as equity shares) are issued to shareholders as a result of their
UNIT 1
Understanding Financial
Statements
NOTES investment into the company’s equity. The common stockholders receive dividends
as declared by the company and they also have voting rights.
• Additional Paid-In Capital: The amount of capital contributed by shareholders in
excess of the par value of the common stock.
Additionally, other business forms may have:
1. Drawings: Any cash withdrawn by the owner or the proprietor for his personal
use that reduces the amount of capital is called the ‘drawing’ of the business.
2. Interest on Drawings: It is an income for the partnership type of organisation.
This is payable by the partners to the organisation when they use drawings from
the business.
Let us have a look on the Balance Sheet of Asian paints prepared for the year ending
March, 31, 2023 for better understanding. This balance sheet has been prepared in the
prescribed format according to schedule III of the company act, 2013.

1.4.8 CONSOLIDATED BALANCE SHEET OF ASIAN PAINT

as at 31st March, 2023
Table 1.4: Consolidated Balance Sheet

12

(Continues)
 FINE005
Financial Analysis and
Business Valuation
Table 1.4: Consolidated Balance Sheet (Continued)
NOTES

Source: https://www.asianpaints.com/content/dam/asianpaints/website/secondary-navigation/
investors/annual-reports/2022-2023/ConsolidatedFinancialStatements.pdf

QUICK INTERPRETATION
In the year ending March 2023:
(a) The company’s borrowing has risen from 731.12 crore to 896.06 crore.
(b) There is an increase in investments from 2180.70 crore to 2697.00 crore.
(c) Trade Receivables have gone from 4636.94 crore to 3871.44 crore.
(d) There is an increase in Non-current assets (Fixed assets) from 7832.12 crore to
9262.84 crore
(e) The situation of cash and cash equivalent has gone down from 621.72
crore to 523.10 crore.
(f) Investments have also gone up from 551.36 crore to 782.98 crore.

1.4.9 IMPORTANCE OF BALANCE SHEET

The balance sheet of a company reflects the position of assets, liabilities and shareholders’
equity on a particular day. The following are the important usage of the balance sheet:
(a) It helps the business owners to evaluate their financial standing.
(b) It provides signals like, if current assets are more than current liabilities, the firm 13
is likely to get favourable position to cover short term financial obligations.
UNIT 1
Understanding Financial
Statements
NOTES (c) It helps in comparing its position from the past trend thus tracking the
performance of the firm.
(d) The important financial ratios such as, Debt-equity ratio, quick ratio, current
ratio etc. can be obtained from the balance sheet to analyze financial
performance.
(e) It provides basis for computing rates of return to the investors.
(f) The balance sheet also helps in comparing with the competitors.

CHECK YOUR PROGRESS – I

1. It is said that a balance sheet represents the snapshot of a company’s financial
position at a specific period say one year.
(a) True
(b) False
2. Liabilities include only current liabilities.
(a) True
(b) False
3. Shareholders’ equity represents the total amount of money that needs to repaid in
one year only.
(a) True
(b) False
4. Prepaid expenses are classified as current assets on the balance sheet.
(a) True
(b) False
5. The income statement, cash flow statement, and balance sheet are the three main
financial statements.
(a) True
(b) False

1.5 INCOME STATEMENT

The Income Statement, also known as the Profit and Loss Statement, is a financial
statement that provides a summary of a company’s revenues and expenses over
a specific period. It helps to assess the profitability of a business during a given
timeframe.
The following is the list of items that are common in an Income Statement:

REVENUE (SALES)
• Sales Revenue: The total amount of money generated by the sale of goods or
14 services before any expenses are deducted.
• Net Sales: Sales revenue minus any returns, allowances, and discounts.
 FINE005
Financial Analysis and
Business Valuation
• Other Income: Income generated from sources other than the primary business NOTES
activities, such as interest, royalties, or fees.

EXPENSES
• Materials cost, cost related to employee benefits etc.
• Selling, general, and administrative expenses (SG&A). Depreciation and
Amortization: Non-cash expenses that allocate the cost of long-term assets
over their useful life.
• Interest Expense: The cost of borrowing money.
• Income Tax Expense: The amount of income tax owed to the government based on
the company’s taxable income.
In addition to above terms, we should also know the following terminology that do
not appear in Income Statement format as per schedule III of Company’s Act but are
commonly reflected in income statement prepared for analysis purpose.
• Cost of Goods Sold (COGS): The direct costs associated with producing goods or
services, including materials, labor, and overhead.
• Gross Profit: Net sales revenue minus the cost of goods sold. It represents the
basic profitability of the core business operations.
• Operating Expenses: Costs incurred in the day-to-day operations of the business,
including selling, general, and administrative expenses (SG&A).

PROFIT MEASURES
• Operating Income (Operating Profit): Gross profit minus operating expenses.
It reflects the profitability of the company’s core operations.
• Net Income (Net Profit or Net Earnings): The final amount after deducting all
expenses, including taxes, from the revenue. It represents the overall profitability
of the company.
• Earnings Before Interest and Taxes (EBIT): A measure of a company’s profitability
before considering interest and tax expenses.
• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): Similar
to EBIT but excludes depreciation and amortization. It provides a measure of
operating performance without accounting for non-cash expenses.
• Earnings per Share (EPS): Monetary value of earnings per outstanding share of
common stock for a company.
• Basic EPS: Calculated by dividing the net income available to common shareholders
by the weighted average number of common shares outstanding.

1.5.1 INCOME STATEMENT FORMATS

The Income Statement is crucial for investors, analysts, and management to
evaluate a company’s profitability, operational efficiency, and overall financial
performance over a specific period. It is often analyzed together with the Balance
Sheet and Cash Flow Statement to provide a comprehensive view of a company’s
financial health.
15
The income statement can be presented in three formats:
UNIT 1
Understanding Financial
Statements
NOTES 1.5.2 FORMAT 1 – THE T FORMAT – TRADITIONAL FORMAT
Table 1.5: Format 1 – The T Format – Traditional Format

Particulars Amount (Rs.) Particulars Amount (Rs.)

To Opening Stock XXX By Sales XXX
To Purchases XXX By Closing stock XXX
To Direct Expenses XXX
To Gross Profit XXX
XXX XXX
To Operating Expenses XXX By Gross Profit XXX
To Operating Profit XXX
XXX
To Non-Operating XXX By Operating Profit XXX
Expenses
To Exceptional Items XXX By Other Income XXX
To Finance Cost XXX
To Depreciation XXX
To Net Profit Before XXX
Tax
XXX XXX

1.5.3 FORMAT 2 – AS SET BY STANDARD SETTING BODIES

• Single-Step Income Statement
• Multi-Step Income Statement
Each format provides a different level of detail and organization of the various components.

(A) SINGLE-STEP INCOME STATEMENT

The Single-Step Income Statement is a straightforward format that presents all revenues
and gains together and all expenses and losses together, resulting in a single bottom-line
figure. The Single-Step Income Statement is particularly useful for small businesses with
simpler financial structures. All revenues and gains are added together, and all expenses
and losses are grouped separately. The final result is a single net income figure.

(B) MULTI-STEP INCOME STATEMENT

The Multi-Step Income Statement provides more detail by separating the operating
and non-operating sections, helping users to analyze different aspects of a company’s
profitability. The Multi-Step Income Statement breaks down revenues and expenses into
operating and non-operating categories.
• Gross profit is calculated by subtracting the cost of goods sold from operating revenues.
• Operating income is obtained by subtracting operating expenses from gross profit.
16 • Net income is then determined after accounting for non-operating revenues,
non-operating expenses, and income tax.
 FINE005
Financial Analysis and
Business Valuation
The choice between these formats depends on the complexity of the business and the NOTES
level of detail required by financial statement users. Larger, more complex businesses
often prefer the Multi-Step format for its ability to provide a more detailed analysis of
various income components. The following is the format as per scheduled III.

1.5.4 F ORMAT 3 STATEMENT OF PROFIT AND LOSS—PART 2

OF SCHEDULE III
Name of the Company.........................
Statement of Profit and Loss for the period ended................
Table 1.6: Part II – Statement of Profit and Loss

Particulars Note Figures as at the Figures for the

No. end of current previous reporting
reporting period period
I Revenue from operations
II Other Income
III Total Income (I + II)
IV EXPENSES
Cost of materials consumed
Purchases of Stock-in-Trade
Changes in inventories of
finished goods, Stock-in
-Trade and work-in progress
Employee benefits expense
Finance costs
Depreciation and
amortization expenses
Other expenses
Total expenses (lV)
V Profit/(loss) before exceptional
items and tax (I – IV)
VI Exceptional Items
VII Profit/(loss) before exceptions
items and tax (V – VI)
VIII Tax expense:
(1) Current tax
(2) Deferred tax
IX Profit (Loss) for the period
from continuing operations
(VII – VIII)
X Profit/(loss) from
discontinued operations 17

(Continues)
UNIT 1
Understanding Financial
Statements
Table 1.6: Part II - Statement of Profit and Loss (Continued)
NOTES
Particulars Note Figures as at the Figures for the
No. end of current previous reporting
reporting period period
XI Tax expenses of discontinued
operations
XII Profit/(loss) from
Discontinued operations
(after tax) (X – XI)
XIII Profit/(loss) for the period
(IX + XII)
XIV Other Comprehensive Income
A. (i) Items that will not be
reclassified to profit or
loss
(ii) Income tax relating to
items that will not be
reclassified to profit or
loss
B. (i) Items that will be
reclassified to profit or
loss
(ii) lncome tax relating
to items that will be
reclassified to profit
or loss
XV Total Comprehensive Income
for the period (XIII + XIV)
Comprising Profit
(Loss) and Other comprehensive
Income for the period)
XVI Earnings per equity share
(for continuing operation):
(1) Basic
(2) Diluted
XVII Earnings per equity share
(for discontinued operation):
(1) Basic
(2) Diluted
XVIII Earning per equity share
(for discontinued &
continuing operation)
18 (1) Basic
(2) Diluted
 FINE005
Financial Analysis and
Business Valuation
1.5.5  ENERAL INSTRUCTIONS FOR PREPARING OF STATEMENT OF
G NOTES
PROFIT AND LOSS
1. The Statement of Profit and Loss shall include:
(1) Profit of loss for the Period;
(2) Other Comprehensive Income for the period
The sum of (1) and (2) above is “Total Comprehensive Income”
2. Revenue from operations shall disclose separately in the notes:
(a) sale of products (including Excise Duty);
(b) sale of services
(c) G rants or donations received (relevant in case of section 8 companies only);
and”
(d) other operating revenues.
3. Finance Costs: Finance costs shall be classified as:
(a) interest;
(b) dividend on redeemable preference shares;
(c) exchange differences regarded as an adjustment to borrowing costs; and
(d) other borrowing costs (specify nature).
4. Other Income: Other income shall be classified as:
(a) interest Income;
(b) dividend Income; and
(c) o ther non-operating income (net of expenses directly attributable to such
income)
5. Other Comprehensive Income shall be classified into:
(a) Items that will not be reclassified to profit or loss
(i) Changes in revaluation surplus;
(ii) Re-measurements of the defined benefit plans;
(iii) Equity Instruments through Other Comprehensive Income;
(iv) Fair value changes relating to own credit risk of financial liabilities des-
ignated at fair value through profit or loss;
(v) Share of Other Comprehensive Income in Associates and Joint
Ventures, to the extent not to be classified into profit or loss; and
(vi) Others (specify nature).
(b) Items that will be reclassified to profit or loss;
(i) Exchange differences in translating the financial statements of a ­foreign
operation;
(ii) Debt instruments through Other Comprehensive Income;
(iii) The effective portion of gains and loss on hedging instruments in a
cash flow hedge;
(iv) Share of other comprehensive income in Associates and Joint Ventures, 19
to the extent to be classified into profit or loss; and
(v) Others (specify nature)
UNIT 1
Understanding Financial
Statements
NOTES Let us have a look on the Statement of Profit and Loss of Asian paints prepared for the
year ending March, 31, 2023 for better understanding. This has been prepared in the
prescribed format according to schedule III of the company act, 2013.

CONSOLIDATED STATEMENT OF PROFIT AND LOSS OF ASIAN PAINTS

for the year ended 31st March, 2023
Table 1.7: Statement of Profit and Loss
(` in Crores)
Year Year
Parculars Notes
2022-23 2021-22
REVENUE FROM OPERATIONS
Revenue from Sale of Products 23A 34,253.35 28,830.02
Revenue from Sale of Services 23A 114.48 93.46
Other Operang Revenue 23A 120.76 177.80
Other Income 24 386.48 380.01
Total Income (I) 34,875.07 29,481.29
EXPENSES
Cost of Materials Consumed 25A 17,330.58 16,254.59
Purchases of Stock-in-Trade 25B 4,135.65 3,371.13
Changes in inventories of finished goods, Stock-in-Trade and work-in-progress 25C (309.73) (1,324.97)
Employee Benefits Expense 26 2,028.07 1,786.67
Other Expenses 27 5,044.18 4,210.25
Total Expenses (II) 28,228.75 24,297.67
EARNING BEFORE INTEREST, TAX, DEPRECIATION AND AMORTISATION (EBITDA) 6,646.32 5,183.62
(I-II)
Finance Costs 28 144.45 95.41
Depreciaon and Amorsaon Expense 29 858.02 816.36
PROFIT BEFORE SHARE OF PROFIT IN ASSOCIATES AND EXCEPTIONAL ITEMS 5,643.85 4,271.85
Share of profit in Associates 38 93.85 31.57
PROFIT BEFORE EXCEPTIONAL ITEMS AND TAX 5,737.70 4,303.42
Exceponal Items 41 48.87 115.70
PROFIT BEFORE TAX 5,688.83 4,187.72
Tax Expense 9
Current Tax 1,504.14 1,161.53
Short tax provision for earlier years 6.64 2.82
Deferred Tax (17.28) (61.44)
Total tax expense 1,493.50 1,102.91
PROFIT AFTER TAX 4,195.33 3,084.81
OTHER COMPREHENSIVE INCOME (OCI)
A. Items that will not be reclassified to Profit or Loss
(i) (a) Remeasurement of the defined benefit plans 34 (10.21) 4.59
(b) Income tax benefit/(expense) on remeasurement of defined benefit plans 2.62 (0.96)
(ii)(a) Net fair value gain/(loss) on investments in equity instruments through OCI 90.19 (82.31)
(b) Income tax (expense)/benefit on net fair value gain on investments in equity (10.58) 9.59
instruments through OCI
(iii) Share of OCI in Associates (0.77) (0.05)
B. Items that will be reclassified to Profit or Loss
(i) (a) Net fair value (loss) on investment in debt instruments through OCI (5.43) (3.26)
(b) Income tax benefit on net fair value gain on investment in debt instruments 0.63 0.39
through OCI
(ii) Exchange difference arising on translaon of foreign operaons (53.41) (153.65)
Total Other Comprehensive Income (A+B) 13.04 (225.66)
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 4,208.37 2,859.15

20 (Continues)
 FINE005
Financial Analysis and
Business Valuation
Table 1.7: PART-II Statement of Profit and Loss (Continued)
NOTES
(` in Crores)
Year Year
Particulars Notes 2022–23 2021–22
PROFIT FOR THE YEAR ATTRIBUTABLE TO :
- Owners of the Company 4,106.45 3,030.57
- Non-controlling interest 88.88 54.24
4,195.33 3,084.81
OTHER COMPREHENSIVE INCOME FOR THE YEAR ATTRIBUTABLE TO :
- Owners of the Company 24.51 (212.31)
- Non-controlling interest (11.47) (13.35)
13.04 (225.66)
TOTAL COMPREHENSIVE INCOME FOR THE YEAR ATTRIBUTABLE TO :
- Owners of the Company 4,130.96 2,818.26
- Non-controlling interest 77.41 40.89
4,208.37 2,859.15
Earnings per equity share (Face value of ` 1 each) 32
Basic (in `) 42.83 31.59
Diluted (in `) 42.82 31.59
Significant accounting policies and key accounting estimates and judgements 1
See accompanying notes to the Consolidated Financial Statements 2-45

Source: https://www.asianpaints.com/content/dam/asianpaints/website/secondary-navigation/
investors/annual-reports/2022-2023/ConsolidatedFinancialStatements.pdf

INTERPRETATION
• The profit and loss statement shows a significant improvement in the company’s
financial performance compared to the previous year.
• Revenue from operations increased, driven by higher sales of products and
services.
• Total expenses also rose, mainly due to increased costs of materials and employee
benefits.
• However, the company managed to enhance its profitability, as evidenced by
higher earnings before interest, taxes, depreciation, and amortization (EBITDA)
and profit before tax.
• After-tax profit surged, indicating improved bottom-line performance.
• Additionally, earnings per equity share rose, reflecting higher profitability on a
per-share basis.
• Overall, the company demonstrated strong financial growth, suggesting effective
management and promising prospects for future expansion.

1.5.6 IMPORTANCE OF AN INCOME STATEMENT

The Income Statement is a crucial financial statement that provides valuable insights into
a company’s financial performance over a specific period of time. It is used for:
• Profitability Assessment: The primary purpose of the Income Statement is to
measure a company’s profitability. It shows whether the company is generating a
profit or incurring a loss during a given period. 21
UNIT 1
Understanding Financial
Statements
NOTES • Investor Decision-Making: Investors use the Income Statement to assess the
company’s ability to generate returns. Positive net income is generally seen as a
favorable sign, while consistent losses may raise concerns.
• Financial Health Evaluation: The Income Statement, when analyzed in conjunction
with the Balance Sheet and Cash Flow Statement, provides a comprehensive view
of a company’s financial health. It helps in understanding how well a company is
managing its operations and resources.
• Operational Efficiency Analysis: The statement breaks down revenues and
expenses into various categories, allowing for a detailed analysis of operational
efficiency. This includes understanding the cost of goods sold, operating expenses,
and gross and operating profit margins.
• Comparison and Benchmarking: Companies can compare their Income Statements
over different periods to identify trends and assess performance improvement or
deterioration. Additionally, comparisons with industry benchmarks or competitors’
financials can provide valuable insights.
• Investor Communication: Publicly traded companies are required to publish
their financial statements, including the Income Statement, regularly. This
transparency helps build trust and confidence among investors, analysts, and
other stakeholders.
• Budgeting and Planning: Businesses use historical Income Statements as
a basis for future financial planning and budgeting. By understanding past
revenue and expense patterns, companies can make informed projections for
future periods.
• Creditworthiness Assessment: Lenders and creditors use the Income Statement to
evaluate a company’s creditworthiness. A company with consistent profitability is
generally viewed as less risky, making it more likely to obtain favorable credit terms.
• Management Decision-Making: Company management uses the Income
Statement to make strategic decisions, set performance goals, and identify areas
for improvement. It helps in resource allocation and determining the effectiveness
of various business strategies.
• Tax Planning: The Income Statement provides information on taxable income,
helping businesses plan for tax obligations and comply with tax regulations. It aids
in understanding the impact of different tax strategies on the bottom line.

Let us have a look on Income Statement of Tata Motors for the year ending March 2018

Table 1.8: Income Statement of Tata Motors for the Year Ending March 2018

(` in crores)
Notes Year ended March Year ended March
31, 2018 31, 2017
I. Revenue from operaons 32 59,624.69 49,054.49
II. Other Income 33 1,557.60 981.06
III. Total Income (I+II) 61,182.29 50,035.55
IV. Expenses
(a) Cost of materials consumed 37,080.45 27,651.65
(b) Purchases of products for sale 4,762.41 3,945.97
( c) Changes in inventories of finished goods, work-in-progress and products for sale 842.05 (252.14)
(d) Excise duty 32(2) 793.28 4,738.15
(e)22 Employee benefits expense 34 3,966.73 (Continues)
3,764.35
(f) Finance costs 35 1,744.43 1,569.01
(g) Foreign exchange (gain)/loss (net) 17.14 (252.78)
(h) Depreciaon and amorsaon expense 3,101.89 3,037.12
(i) Product development/Engineering expenses 474.98 454.48
(j) Other expenses 36 9,234.27 8,335.90
(k) Amount capitalised (855.08) (941.60)
Total Expenses (IV) 61,162.55 52,050.11
V. Profit/(loss) before exceponal items and tax (III-IV) 19.74 (2,014.56)
VI. Exceponal items
(a) Provision for impairment of investment in a subsidiary - 123.17
(b) Employee separaon cost 3.68 67.61
 (` in crores)
Notes Year ended March FINE005
Year ended March
Financial Analysis and
31, 2018 31, 2017
I. Revenue from operaons 32 59,624.69Business Valuation
49,054.49
Table 1.8: Income Statement of Tata Motors for the Year Ending March 2018 (Continued)
II.
III.
Other Income
Total Income (I+II)
33 1,557.60
61,182.29
NOTES 981.06
50,035.55
IV. Expenses (` in crores)
(a) Cost of materials consumed 37,080.45 27,651.65
(b) Purchases of products for sale Notes Year ended March
4,762.41 Year ended March
3,945.97
( c) Changes in inventories of finished goods, work-in-progress and products for sale 31,842.05
2018 31, 2017
(252.14)
I. Revenue
(d) Excise fromdutyoperaons 32
32(2) 59,624.69
793.28 49,054.49
4,738.15
II. OtherEmployee
(e) Income benefits expense 33
34 1,557.60
3,966.73 981.06
3,764.35
III. Total Income
(f) Finance(I+II)
costs 35 61,182.29
1,744.43 50,035.55
1,569.01
IV. Expenses
(g) Foreign exchange (gain)/loss (net) 17.14 (252.78)
(a) Depreciaon
(h) Cost of materials and consumed
amorsaon expense 37,080.45
3,101.89 27,651.65
3,037.12
(b) Product
(i) Purchases of products for sale
development/Engineering expenses 4,762.41
474.98 3,945.97
454.48
( c) Other
(j) Changes in inventories of finished goods, work-in-progress and products for sale
expenses 36 842.05
9,234.27 (252.14)
8,335.90
(d) Amount
(k) Excise duty capitalised 32(2) 793.28
(855.08) 4,738.15
(941.60)
(e) Expenses
Total Employee(IV) benefits expense 34 3,966.73
61,162.55 3,764.35
52,050.11
V. (f) Financebefore
Profit/(loss) costs exceponal items and tax (III-IV) 35 1,744.43
19.74 1,569.01
(2,014.56)
VI. (g) Foreignitems
Exceponal exchange (gain)/loss (net) 17.14 (252.78)
(h) Provision
(a) Depreciaon and amorsaon
for impairment expense in a subsidiary
of investment 3,101.89- 3,037.12
123.17
(i)
(b) Product development/Engineering
Employee separaon cost expenses 474.98
3.68 454.48
67.61
((j)c) Provision
Other expensesfor impairment of capital work-in-progress and intangibles under development 36
37(a) 9,234.27
962.98 8,335.90-
(k) Others
(d) Amount capitalised 37(b) (855.08)
- (941.60)
147.93
Total Expenses
VII. Profit/(loss) (IV) tax (V-VI)
before 61,162.55
(946.92) 52,050.11
(2,353.27)
V.
VIII. Profit/(loss)
Tax before exceponal
expense/(credit) (net) items and tax (III-IV) 19.74 (2,014.56)
VI. Exceponal
(a) Current items
tax 92.63 57.06
(a) Deferred
(b) Provision tax for impairment of investment in a subsidiary -
(4.70) 123.17
19.27
(b) Employee
Total tax separaon cost
expense/(credit) 3.68
87.93 67.61
76.33
IX. (Profit/(loss)
c) Provision forfor
theimpairment of capital work-in-progress
year from connuing and intangibles under development
operaons (VII-VIII) 37(a) 962.98
(1,034.85) -
(2,429.60)
X. (d)
OtherOthers
comprehensive income/(loss): 37(b) - 147.93
VII. Profit/(loss)
(A) (i) before
Items taxwill
that (V-VI)
not be reclassified to profit and loss: (946.92) (2,353.27)
VIII. Tax expense/(credit) (net)
(a) Remeasurement gains and (losses) on defined benefit obligaons (net) 18.24 8.24
(a) Current (b)tax Equity instruments at fair value through other comprehensive income 92.63
44.04 57.06
73.84
(b) (ii)
DeferredIncometax tax (expense)/credit relang to items that will not be reclassified to (4.70) 19.27
Total tax expense/(credit)
profit or loss 87.93
(6.27) 76.33
(3.12)
IX. Profit/(loss)
(B) (i) for the
Items year
that willfrom connuingto
be reclassified operaons (VII-VIII)
profit or loss - gains and (losses) in cash flow hedges (1,034.85)
(19.56) (2,429.60)
23.32
X. Other(ii)
comprehensive
Income taxincome/(loss):
(expense)/credit relang to items that will be reclassified to profit or loss 6.77 (8.07)
(A) other
Total (i) comprehensive
Items that will not be reclassified
income/(loss), net to
of profit
taxes and loss: 43.22 94.21
XI. (a) Remeasurement
Total comprehensive income/(loss)gains andyear
for the (losses)
(IX+X)on defined benefit obligaons (net) 18.24
(991.63) 8.24
(2,335.39)
XII. Earnings per(b) equityEquity
shareinstruments
(EPS) at fair value through other comprehensive income 39 44.04 73.84
(ii) Income
(A) Ordinary sharestax(face
(expense)/credit relang
value of ` 2 each) : to items that will not be reclassified to
(i) profit or loss
Basic ` (6.27)
(3.05) (3.12)
(7.15)
(B) (ii)
(i) Items that will be reclassified to profit or loss - gains and (losses) in cash flow hedges
Diluted (19.56)
(3.05) 23.32
(7.15)
`
(B) ‘A’ (ii) Ordinary
Income tax (expense)/credit
shares (face value of `relang
2 each)to: items that will be reclassified to profit or loss 6.77 (8.07)
Total other
(i) comprehensive
Basic income/(loss), net of taxes 43.22
(3.05) 94.21
(7.15)
`
XI. Total comprehensive
(ii) Diluted income/(loss) for the year (IX+X) (991.63)
(3.05) (2,335.39)
(7.15)
`
XII. Earnings pernotes
See accompanying equity toshare (EPS)
financial statements 39
(A) Ordinary shares (face value of ` 2 each) :
As per our report(i) of Basic
even date aached For and on behalf of the Board`
(3.05) (7.15)
(ii) Diluted (3.05) ` (7.15)
For B S R & Co. LLP N CHANDRASEKARAN [DIN: 00121863]
N MUNJEE [DIN:00010180] GUENTER BUTSCHEK [DIN: 07427375]
(B) ‘A’ Ordinary shares (face value of ` 2 each) :
Chartered Accountants Chairman CEO and Managing Director
(i) Basic V K JAIRATH [DIN:00391684]` (3.05) (7.15)
Firm’s Registraon No: 101248W/W-100022
(ii) Diluted ` S (3.05) [DIN: 01793948] (7.15)
B BORWANKAR
F S NAYAR [DIN:00003633] ED and Chief Operang Officer
See accompanying notes to financial statements
P B BALAJI
YEZDI
As per NAGPOREWALLA
our report of even date aached O P and
For BHATT [DIN:00548091]
on behalf of the Board Group Chief Financial Officer
Partner
H K SETHNA [FCS: 3507]
Membership No.LLP
For B S R & Co. 049265 N CHANDRASEKARAN [DIN: 00121863] R
N SPETH
MUNJEE [DIN:03318908]
[DIN:00010180] GUENTER BUTSCHEK [DIN: 07427375]
Company Secretary
Mumbai,
CharteredMay 23, 2018
Accountants Chairman CEO and Managing Director
Firm’s Registraon No: 101248W/W-100022 V K JAIRATH
Directors [DIN:00391684] Mumbai, May 23, 2018
S B BORWANKAR [DIN: 01793948]
ED
Source: https://investors.tatamotors.com/financials/73-ar-html/pdf/122.pdf
F S NAYAR [DIN:00003633] and Chief Operang Officer
P B BALAJI
YEZDI NAGPOREWALLA O P BHATT [DIN:00548091] Group Chief Financial Officer
Partner
H K SETHNA [FCS: 3507]
Membership No. 049265 R SPETH [DIN:03318908]
Company Secretary
Mumbai, May 23, 2018
Directors Mumbai, May 23, 2018

23
UNIT 1
Understanding Financial
Statements
NOTES CHECK YOUR PROGRESS – II
1. The income statement provides a summary of a company’s financial performance
over a specific period, such as a quarter or a year.
(a) True
(b) False
2. Net income represents the total revenues earned by a company minus all expenses,
including taxes.
(a) True
(b) False
3. Gross profit is calculated by subtracting operating expenses from total revenues.
(a) True
(b) False
4. Earnings per share (EPS) is a measure of a company’s profitability relative to its total
assets.
(a) True
(b) False
5. Non-operating income, such as gains from the sale of investments, is excluded from
the calculation of operating income.
(a) True
(b) False

1.6 STATEMENT OF CASHFLOWS

There is another important financial statements known as statement of Cash Flows
that provides information about the cash inflows and outflows of a business during
a specific period. It is one of the key financial statements, along with the Balance
Sheet and Income Statement, and is essential for understanding a company’s liquidity,
solvency, and overall financial health. This is covered in detail in unit 3 of this self-
learning material.

1.7 STATEMENT OF CHANGES IN EQUITY

The Statement of Changes in Equity is a financial statement that provides a summary
of the changes in a company’s equity accounts over a specific period. It is used for the
following reasons:
• Understanding Changes in Ownership: The Statement of Changes in Equity helps
stakeholders understand how the ownership interests in a company have changed
over time. This includes changes in common stock, additional paid-in capital,
retained earnings, and other equity components.

24
 FINE005
Financial Analysis and
Business Valuation
• Detailed Breakdown of Equity Accounts: It provides a detailed breakdown of the NOTES
various components of equity, such as common stock, additional paid-in capital,
retained earnings, and any other comprehensive income. This breakdown is crucial
for investors and analysts seeking a comprehensive understanding of a company’s
financial position.
• Compliance with Reporting Standards: Many accounting standards and regulations
require companies to prepare and present a Statement of Changes in Equity as
part of their financial reporting. For example, International Financial Reporting
Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) prescribe
the format and content of this statement.
• Identification of Reasons for Changes: The statement helps in identifying and
explaining the reasons behind changes in equity accounts. For instance, it
distinguishes between net income generated during the period, dividends paid
to shareholders, changes in accounting policies, and other adjustments affecting
equity.
• Investor and Analyst Decision-Making: Investors and financial analysts use the
Statement of Changes in Equity to assess the financial health and performance of a
company. By understanding how equity has changed, stakeholders can make more
informed investment decisions.
• Insight into Retained Earnings: Retained earnings represent the accumulated
profits that a company has retained for reinvestment or distribution. The statement
shows the net income earned during the period and adjustments, providing insight
into how much profit has been retained and how much has been distributed as
dividends.

CHECK YOUR PROGRESS – III

1. The statement of changes in equity displays the evolution of the company’s equity
accounts over a given time frame, like a quarter or a year.
(a) True
(b) False
2. The issuing of new shares, dividend payments, and net income for the quarter are
examples of common transactions that are included in the statement of changes
in equity.
(a) True
(b) False
3. Information regarding the company’s cash flows from financing, investing, and
operating activities during the period is available in the statement of changes in
equity.
(a) True
(b) False

25
 Table 1.9: Asian Paints Statement of Changes in Equity

Statement of Changes in Equity

for the year ended 31st March, 2022
A) EQUITY SHARE CAPITAL (` in Crores)
As at As at
Particulars 31.03.2022 31.03.2021
Balance at the beginning of the reporting year 95.92 95.92
Changes in Equity Share capital to prior period errors - -
Restated balance at the beginning of the current reporting period 95.92 95.92
Changes in Equity Share capital during the year - -
Balance at the end of the reporting year 95.92 95.92

B) OTHER EQUITY
(` in Crores)
Items of Other
Reserves and Surplus Comprehensive Income (OCI)
Particulars Remeasurement Share based Debt Equity Total
Capital Capital Redemption General Retained of defined benefit payment Treasury Trust
instruments instruments
Reserve Reserve Reserve earnings plans reserve shares reserve
through OCI through OCI
Balance as at 1st April, 2020 (A) 44.38 0.50 4,166.74 4,994.52* (21.08) - - - 2.48 168.63 9,356.17
Additions during the year :
Profit for the year - - - 3,051.80 - - - - - - 3,051.80
Items of OCI for the year, net of tax
Remeasurement of the defined benefit plans - - - - (3.98) - - - - - (3.98)
Net fair value gain on investments in equity instruments through OCI - - - - - - - - - 52.38 52.38
Net fair value gain on investments in debt instruments through OCI - - - - - - - - 2.13 - 2.13
Total Comprehensive Income for the year 2020-21 (B) - - - 3,051.80 (3.98) - - - 2.13 52.38 3,102.33
Reductions during the year :
Dividends (Refer note 30) - - - (465.23) - - - - - - (465.23)
Total (C) - - (465.23) - - - (465.23)
Balance as at 31 stMarch, 2021 (D) = (A+B+C) 44.38 0.50 4,166.74 7,581.09 (25.06) - - - 4.61 221.01 11,993.27
Additions during the year :
Profit for the year - - - 3,134.71 - - - - - - 3,134.71
Items of OCI for the year, net of tax
Remeasurement of the defined benefit plans - - - - 3.28 - - - - - 3.28
Net fair value (loss) on investments in equity instruments through OCI - - - - - - - - - (72.72) (72.72)
Net fair value (loss) on investments in debt instruments through OCI - - - - - - - - (2.87) - (2.87)
Total Comprehensive Income for the year 2021-22 (E) - - - 3,134.71 3.28 - - - (2.87) (72.72) 3,062.40
Reductions during the year :
Dividends (Refer note 30) - - - (1,740.95) - - - - - - (1,740.95)
Share based payment expense - - - - - 13.40 - - - - 13.40
Net Income of ESOP Trust for the year - - - - - - - 0.05 - - 0.05
Purchase of Treasury shares by ESOP trust during the year - - - - - - (75.00) - - - (75.00)
Total (F) - - - (1,740.95) - 13.40 (75.00) 0.05 - - (1,802.50)
Balance as at 31st March, 2022 (D+E+F) 44.38 0.50 4,166.74 8,974.85 (21.78) 13.40 (75.00) 0.05 1.74 148.29 13,253.17
*Refer note 39(a) on Amalgamation and Acquisitions
Significant accounting policies and Key accounting estimates and judgements (Refer note 1)
See accompanying notes to the Financial Statements (Refer note 2-48)

As per our report of even date attached For and on behalf of the Board of Directors of Asian Paints Limited
CIN: L24220MH1945PLC004598
For Deloitte Haskins & Sells LLP Deepak Satwalekar Amit Syngle
Chartered Accountants Chairman Managing Director & CEO
F.R.N: 117366W/W-100018 DIN: 00009627 DIN: 07232566
Rupen K. Bhatt Milind Sarwate R J Jeyamurugan
Partner Chairman of Audit Committee CFO & Company Secretary
Membership No: 046930 DIN: 00109854
Mumbai Mumbai
10 th May, 2022 10 th May, 2022

Source: https://www.asianpaints.com/content/annualreport/annual-report-22-23.html
 FINE005
Financial Analysis and
Business Valuation
1.8 CHANGES IN DEBT NOTES
A financial statement known as the Statement of fluctuations in Net Debt provides
an overview of an organization’s net debt fluctuations during a specific period. Net
debt is a critical financial metric that is used to assess the financial health of entities
such as governments, corporations, and other organizations that may have significant
debt. The opening balance of net debt at the start of the period is usually the starting
point for creating a Statement of Changes in Net Debt, which subsequently tracks
the numerous changes that happened during that period. The sources and purposes
of the monies that have affected net debt are listed in the statement. Here’s how
it works:
1. Opening Net Debt: The net debt amount at the beginning of a reporting
period should be the starting point. The difference between an organization’s
or company’s total debt and its total cash and cash equivalents is commonly
used to compute net debt. It shows the difference between the amount of
money an entity has on hand to pay down its debt and the amount it owes
(its debt).
2. Funding Sources: Borrowings: New debt that has been issued during the period.
• Income: Any income or revenue generated during the period, such as sales,
fees, or taxes.
• Grants or subsidies: Any financial assistance received from external sources.
• Sale of assets: If the organization has sold assets, this could contribute to
reducing the net debt.
3. Funds Uses: The uses of funds that have resulted in a rise in net debt are
described in this section. They could be used for:
• Principle repayments: The total amount of principal repaid throughout the loan.
• Interest payments: The amount of interest paid on the debt during that
time.
• Operating expenses: All out-of-pocket expenditures for salary, rent, and
utilities that were incurred during the time.
• Investment expenses: Any money spent or invested during the time frame.

1. Closing Net Balance: The closing balance of the net debt is determined by
deducting the uses of funds from the opening net debt and adding the sources
of money. The net debt balance after the reporting period is represented by the
closing net debt.
2. Net Change in Debt: This is the variation between the net debt at opening and
closing balances. It shows if there has been a rise or fall in net debt over the
time. A decline in net debt is usually seen favorably since it indicates that the
company has managed to lower its debt load.
3. The Statement of Changes in Net Debt: It is an important statement for
assessing an entity’s ability to manage its debt and its overall financial
performance. It is often used by investors, creditors, and management to
monitor financial health and make informed decisions about future financial
strategies. 27
UNIT 1
Understanding Financial
Statements
NOTES CHECK YOUR PROGRESS – IV
1. When a company borrows money by issuing bonds, it increases both its liabilities
and assets on the balance sheet.
(a) True
(b) False
2. Any decline in accounts payable indicates that a company has repaid some of its
short-term debts to suppliers.
(a) True
(b) False
3. Debt issuance costs, such as underwriting fees, are recorded as an expense on the
income statement when incurred.
(a) True
(b) False

1.9 QUALITY OF FINANCIAL STATEMENTS

The quality of financial statements is of paramount importance for several reasons, as
it serves as a critical tool for stakeholders to assess the financial health, performance,
and viability of a business. Investors rely on financial statements to make informed
decisions about buying, holding, or selling securities. Accurate and transparent financial
statements contribute to the confidence of investors in the company’s financial stability
and potential for returns. High-quality financial statements enhance the credibility and
trustworthiness of a company. Stakeholders, including investors, lenders, and regulatory
bodies, are more likely to trust financial information that is accurate, reliable, and
adheres to accounting standards. Creditors, such as banks and financial institutions, use
financial statements to evaluate a company’s creditworthiness before extending loans
or credit.
Reliable financial information helps creditors assess the risk associated with lending
money to the business. Accurate financial data is crucial for effective decision-making for
the management. High-quality financial statements ensure that the company meets these
regulatory requirements, reducing the risk of legal and financial repercussions. Accurate
financial information is essential for proper valuation, whether it’s for mergers and
acquisitions, partnerships, or other transactions. Transparent financial reporting fosters
open communication between the company and its stakeholders. It helps in building and
maintaining positive relationships with shareholders, employees, customers, and the
broader community.
High-quality financial information enables a more accurate analysis of a company’s
financial performance relative to its peers. They provide the basis for calculating taxable
income and ensuring compliance with tax laws and regulations. They provide a historical
perspective that aids in projecting future financial performance and setting realistic
financial goals.
The Financial Accounting Standards Board (FASB) defines it as follows:- Six qualitative
28 factors determine the quality of financial information.
 FINE005
Financial Analysis and
Business Valuation
Figure 1.2: Quality Parameters of Financial Statements
NOTES

Relevance

Faithful
Understandibility Representation

Quality of
Financial
Statement

Timeliness Comparability

Verifiability

(i) Relevance: Data is considered relevant if it can be both predictive and

confirmatory in assisting users in making and assessing economic decisions.
Information’s relevance is influenced by its content and type. If omitting or
misrepresenting information has the potential to influence choices, it is deemed
material. All information relevant to a particular organization should be included
in a financial report.
(ii) Faithful Representation: Financial data faithfully represents the phenomena
it is intended to reflect, as defined by the definition of faithful representation.
This portrayal implies that the financial information is complete, impartial, and
accurate.
(iii) Comparability: This states that users of financial statements can compare
elements of an entity at one point in time and over time, as well as aspects
of other entities at one point in time and over time. Consequently, events
and transactions should be measured and shown uniformly across an entity,
or if they are measured or shown differently, they should be adequately
described.
(iv) Verifiability: it is a quality parameter that ensures the information accurately
portrays what it claims to signify.
(v) Timeliness: This quality indicates that all parties involved have access to
accounting information promptly to make decisions.
(vi) Understandability: The quality of understandability indicates that the
information was presented, classified, and characterized clearly. The financial
reports are written under the presumption that readers are knowledgeable
about the business and its financial activities.
29
UNIT 1
Understanding Financial
Statements
NOTES 1.9.1 SOME WARNING SIGNALS IN FINANCIAL STATEMENTS
INCREASING INVENTORY
The higher inventory suggests that sales of the products are slow. This might cause spoiling
or obsolescence.
Calculate the average inventory for the length of the accounting period, then divide
the results by the sales for current year to find the rising stock. If this proportion is
higher than in prior years, there’s a good chance that there are shares that could not
be sold.

INCREASING RECEIVABLES
Huge receivables are a fantastic thing, but don’t celebrate too soon if it is unsure to be
able to get the number. Customers may occasionally fail to make promised payments,
especially for accounts that have gone unpaid for an extended length of time. Therefore, a
rise in receivables may be a sign that the payments from the clients are not being collected
effectively.

FIXED ASSETS DISPOSAL

Selling equipment that is superfluous for the existing business activities is acceptable.
The issue arises when a business owner sells their fixed assets and uses the proceeds
to pay off debt or cover unforeseen expenses. If the proceeds from the sale of fixed
assets are not reinvested, there might be serious problems with operating income in
the future.

INADEQUATE CASH FLOW PATTERNS

The fact that the company is making some good earnings should not cause the owner to
become blind. It might be the consequence of poor cash flow patterns, which could give
the impression to the investor that receivables collection is inefficient.

REVENUE OBTAINING FROM NON-OPERATIONS

When it comes to determining the state of the company, not all money is made equal.
The main source of revenue on the income statement ought to be the money made from
sales and other commercial activities. It should also be enough to cover the operating
expenditures for the near future. Examine further if the money the company receives from
the sale of fixed assets or long-term investments has been increasing the non-operating
income annually. Make sure the company hasn’t been unintentionally depending on this
kind of revenue to cover its ongoing expenses.
Financial statements offer important information about the company’s performance in
the present and the future, including liquidity and profitability. It would be a better
position to make the best decisions for the business and steer clear of the financial
difficulties that drive out many initiatives if possible warning flags are seen as soon as
they arise.

30
 FINE005
Financial Analysis and
Business Valuation
1.10 TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS NOTES
The following are the financial analysis methods that are most frequently employed:

1.10.1 COMPARATIVE OR HORIZONTAL ANALYSIS

This method provides information on the state of two or more periods by comparing
the profitability and financial position of a company over time. It frequently has to do
with the profit and loss statement and the balance sheet, which are the two crucial
financial statements. The pattern and direction of the financial status and operational
performance are displayed by comparative data. This kind of analysis is also known as
“Trend analysis.”

COMPARATIVE ANALYSIS OF SAFEWAY STORES

CONSOLIDATED INCOME STATEMENT
Table 1.10: Comparative Analysis of HCL Technologies

(Amount in ` Crores)
Income Statement Quarter Ended Growth
30-Jun-19 31-Mar-20 30-Jun-20 YoY QoQ
Revenues 16,425 18,590 17,841 8.6% –4.0%
Direct Costs 10,631 11,151 10,728
Gross Profits 5,794 7,439 7,113 22.8% –4.4%
Research & Development 289 328 342
SG & A 2,105 2,391 2,205
EBITDA 3,401 4.720 4,566 34.3% –3.3%
Depreciation & Amortisation 595 839 906
EBIT 2,806 3,881 3,660 30.5% –5.7%
Foreign Exchange Gains/(Loss) 19 (36) 0
Other Income, net 109 23 205
Provision for Tax 705 707 929
Net gain attributable to redeemable 8 8 13
non-controlling/non-controlling
interest
Net Income 2,220 3,154 2,925 31.7% –7.3%
Source: https://economictimes.indiatimes.com/markets/stocks/earnings/hcl-tech-q1-results-
profit-jumps-32-yoy-to-rs-2925-crore-beats-estimates/articleshow/77011564.cms?from=mdr,
retrieved on 30.06.2024

31
UNIT 1
Understanding Financial
Statements
NOTES COMPARATIVE BALANCE SHEETS
Table 1.11: Comparative Analysis of Safeway Stores

Source: https://www.chegg.com/homework-help/questions-and-answers/q5-using-information-balance-
sheet-profit-loss-statement-calculate-following-ratios-answer-q74024413, retrieved on 30.06.2024

Here’s a step-by-step explanation of horizontal analysis with an example using a fictional

company’s income statement:
Example: Abridged Version of Income Statement of XYZ Corp.
Table 1.12: Abridged Version of Income Statement of XYZ Corp

Year 1 Year 2
Revenue 500,000 600,000
Cost of Goods Sold 300,000 350,000
Gross Profit 200,000 250,000
Operating Expenses 100,000 120,000
Net Income 100,000 130,000

STEP 1: CALCULATE RUPEE CHANGE

To perform horizontal analysis, calculate the Rupee change between the two periods for
32 each item on the income statement. Rupee change is calculated as follows:
Rupee Change = Year 2 Amount – Year 1 Amount
 FINE005
Financial Analysis and
Business Valuation
For example, for Revenue: NOTES
Rupee Change in Revenue = Rs. 600,000 (Year 2) – Rs. 500,000 (Year 1) = Rs. 100,000

STEP 2: CALCULATE PERCENTAGE CHANGE

Next, calculate the percentage change between the two periods for each item. Percentage
change is calculated as follows:
Percentage Change = (Rupee Change/Year 1 Amount) × 100
For example, for Revenue:
Percentage Change in Revenue = (Rs. 100,000/Rs. 500,000) × 100 = 20%

STEP 3: INTERPRET THE RESULTS

Now, interpret the results obtained from the horizontal analysis:
• Revenue increased by Rs. 100,000 or 20% from Year 1 to Year 2. This indicates a
significant growth in sales for the company.
• Cost of Goods Sold increased by Rs. 50,000 or 16.67% from Year 1 to Year 2. This
rise in cost suggests increased expenses related to production or raw materials.
• Gross Profit increased by Rs. 50,000 or 25% from Year 1 to Year 2. The increase in
gross profit is a positive sign which indicates that the profitability of the company
has improved over period.
• Operating Expenses increased by Rs. 20,000 or 20% from Year 1 to Year 2.
The increase in operating expenses may have implications on the company’s
profitability.
• Net Income increased by Rs. 30,000 or 30% from Year 1 to Year 2. This growth in
net income demonstrates the company’s improved overall performance.
Horizontal analysis allows stakeholders to identify trends, both positive and negative, in a
company’s annual financial performance. It provides valuable insights into the company’s
financial health and aids in decision-making and strategic planning for the future.

1.10.2 COMMON SIZE STATEMENTS

These indicate the relationship between the various components of the financial statement
by describing each item as a percentage of the standard item. Comparing the percentage
so computed to the comparable percentages from the prior year or with some other firms
provides insights on the relationship of various components to the standard item or base
used. With the use of such statements, an analyst can assess the financial and operational
characteristics of two companies of dissimilar sizes operating in the same business. Thus,
common size statements are useful for comparing firms within a firm across many years
as well as between firms over a single or several years. This approach is also known as
“vertical analysis.”

C OMMON SIZE BALANCE SHEET OF ABCL COMPANY LTD

ABCL Company Limited
Balance Sheet (Rs. Crores)
33
As on March 31,
UNIT 1
Understanding Financial
Statements
Table 1.13: Common Size Balance Sheet of ABCL Company Ltd
NOTES
Particulars 2020 2021 2020 2021
Liabilities:
Equity Capital Reserves & 356.00 356.00 7.15% 6.30%
Surplus 1,245.00 1,392.67 25.00% 24.65%
Net Worth 1,601.00 1,748.67 32.15% 30.96%
Non-Current Liabilities:
Long-term borrowings 1,562.00 1,466.11 31.37% 25.95%
10% Debentures 1,129.00 1,550.51 22.67% 27.45%
Total Non-Current Liabilities 2,691.00 3,016.62 54.04% 53.40%
Current Liabilities:
Trade Creditors 234.00 299.00 4.70% 5.29%
Short-term Borrowings 357.95 447.81 7.19% 7.93%
Other Current Liabilities &
Provisions 96.00 136.76 1.93% 2.42%
Total Current Liabilities 687.95 883.57 13.81% 15.64%
Total Liabilities 4,979.95 5,648.86 100.00% 100.00%
Assets:
Non-Current assets:
Plant & Equipment 1,964.88 2,632.35 39.46% 46.60%
Less Accumulated Depreciation 186.27 256.34 3.74% 4.54%
Net Plant & Equipment 1,778.61 2,376.01 35.72% 42.06%
Investments 129.82 205.49 2.61% 3.64%
Other Non-Current Assets 57.00 178.34 1.14% 3.16%
Total Non-Current Assets 1,965.43 2,759.84 39.47% 48.86%
Current Assets:
Raw Material 589.74 728.59 11.84% 12.90%
Work-in-Progress 282.50 381.75 5.64% 6.76%
Finished Goods 1,774.84 1,312.80 35.64% 23.24%
Total Inventories 2,647.08 2,423.14 53.15% 42.90%
Trade Debtors 234.76 329.99 4.71% 5.84%
Cash & Bank Balances 55.67 35.92 1.12% 0.64%
Loan & Advances 45.23 45.76 0.91% 0.81%
Other Current Assets 31.78 54.21 0.64% 0.96%
Total Current Assets 367.44 465.88 7.38% 8.25%
Total Assets 4,979.95 5,648.86 100.00% 100.00%
Here’s an explanation of common size statement analysis with an example using a fictional
34 company’s income statement:
 FINE005
Financial Analysis and
Business Valuation
Example: Abridged Version of Income Statement of XYZ Corporation NOTES
Table 1.14: Abridged Version of Income Statement of XYZ Corporation

Year 1 Year 2
Total Revenue 500,000 600,000
Cost of Goods Sold 300,000 350,000
Gross Profit 200,000 250,000
Operating Expenses 100,000 120,000
Net Income 100,000 130,000

STEP 1: IDENTIFY THE COMMON BASE FIGURE

For the income statement, the common base figure is typically the total revenue. So, in
this example, the common base figure is the Revenue for both Year 1 and Year 2.

STEP 2: CALCULATE THE COMMON SIZE PERCENTAGE

To calculate the common size percentage for each line item, divide the line item amount
by the common base figure and multiply by 100.
For example, for Revenue in Year 1:
Common Size Percentage of Revenue (Year 1) = (Rs. 500,000/Rs. 500,000) × 100 = 100%
Similarly, for Revenue in Year 2:
Common Size Percentage of Revenue (Year 2) = (Rs. 600,000/Rs. 600,000) × 100 = 100%

STEP 3: INTERPRET THE RESULTS

Now, interpret the results obtained from the common size analysis:
• Revenue is taken as 100% for both Year 1 and Year 2 because it serves as the
common base figure. This allows stakeholders to see how other line items compare
as a proportion of revenue.
• In Year 1 and Year 2, the cost of products sold as a percentage of revenue is 60%
and 58.33%, respectively. This suggests that from Year 1 to Year 2, the cost of goods
sold as a percentage of sales dropped, which could point to better cost control or
economies of scale.
• In Year 1, Gross Profit as a proportion of revenue was 40%; in Year 2, it was 41.67%.
This demonstrates that from Year 1 to Year 2, the company’s gross profit margin
increased somewhat.
• In Year 1 and Year 2, the percentage of revenue allocated to operating expenses
is 20%. This indicates that, as a percentage of sales, operating expenses did not
change over the two years.
• In Year 1, Net Income as a proportion of revenue was 20%; in Year 2, it was 21.67%.
An improvement in profitability from Year 1 to Year 2 is indicated by the rise in net
income as a percentage of revenue.
When comparing businesses of different sizes or in different industries, common size
statement analysis can be very helpful in pointing out trends and patterns in a company’s 35
financial performance and position. It offers a more uniform perspective on financial
UNIT 1
Understanding Financial
Statements
NOTES accounts, which facilitates decision-making and strategic planning by making it simpler to
identify problem or opportunity areas.

1.10.3 RATIO ANALYSIS

Ratio analysis is a financial analysis technique that involves evaluating and interpreting
the relationships between various financial variables in a company’s financial statements.
The purpose of ratio analysis is to provide insight into the financial performance, liquidity,
solvency, and overall health of a business. It involves the calculation of various financial
ratios that help in assessing different aspects of a company’s operations. By analyzing these
ratios over time or comparing them to industry benchmarks, competitors, or historical
performance, stakeholders can gain valuable insights into a company’s financial health
and performance trends. Ratio analysis is widely used by investors, analysts, creditors,
and management for decision-making, financial planning, and performance evaluation.
Ratio Analysis is covered in detail in subsequent units.

1.10.4 CASH FLOW ANALYSIS

This term denotes the study of actual inflows and outflows of funds within a company. Cash
flows into the firm are known as positive cash flows or cash inflows, and cash movements out
of the business are known as negative cash flows or cash outflows. The difference between
the inflow and outflow of cash is known as the net cash flow. A cash flow statement can be
used to project how cash has been received and spent over a financial year since it details the
sources of cash revenues in addition to the uses for which payments are made. This provides
an overview of the causes of variations in a company’s cash position between the dates of
the two balance statements. Cash Flow Analysis is covered in detail in subsequent units.

CHECK YOUR PROGRESS – V

1. Horizontal analysis looks for patterns and shifts in a company’s performance by
comparing financial data over several periods.
(a) True
(b) False
2. A negative percentage change from the prior year for an income statement item
indicates a decline in the company’s financial performance according to horizontal
analysis.
(a) True
(b) False
3. Each line item on the financial statement is expressed as a percentage of a base
amount, such as total revenue or total assets, using common size statement analysis.
(a) True
(b) False
4. Common size statement analysis is preferable for long-term financial assessment,
while horizontal analysis is more appropriate for short-term financial analysis.

36 (a) True
(b) False
 FINE005
Financial Analysis and
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5. All components are expressed as a percentage of net income when creating a NOTES
common-size income statement.
(a) True
(b) False

1.11 LET US SUM UP

The balance sheet, the income statement or the statement of profit and loss are
statements that provide the accounting and financial information that the users can use
for decision making. They may analyze the available information to compare alternatives
and make informed decisions. The primary goal of financial statement analysis is to assess
the company’s historical performance in terms of liquidity, profitability, operational
effectiveness, and growth potential.
Balance sheet gives an instantaneous picture of the financial health of a firm. It displays
the difference between the assets and obligations. When valuing a firm, the gap between
the two is frequently the starting point.
Income statement is also referred to as a profit and loss statement, this report details
the receipts and payments of the company. Expenses are deducted from revenues to
determine the company’s net income, or profit or loss.
There are formats for preparation of Income Statement and the Balance Sheet.
In the Report Format of a Balance Sheet, assets are presented at the top, followed by
liabilities and equity. This format is more common in larger businesses and is often
preferred for its simplicity. The assets are listed first, followed by liabilities and equity.
This format provides a clear view of the company’s total assets, total liabilities, and total
equity.
The Single-Step Income Statement is a straightforward format that presents all
revenues and gains together and all expenses and losses together, resulting in a
single bottom-line figure. The Single-Step Income Statement is particularly useful for
small businesses with simpler financial structures. All revenues and gains are added
together, and all expenses and losses are grouped separately. The final result is a
single net income figure.
The Multi-Step Income Statement provides more detail by separating the operating
and non-operating sections, helping users to analyze different aspects of a company’s
profitability. The Multi-Step Income Statement breaks down revenues and expenses into
operating and non-operating categories. Gross profit is calculated by subtracting the cost
of goods sold from operating revenues. Operating income is obtained by subtracting
operating expenses from gross profit. Net income is then determined after accounting for
non-operating revenues, non-operating expenses, and income tax.
The Statement of Changes in Equity is a financial statement that provides a summary of
the changes in a company’s equity accounts over a specific period.
A financial statement known as the Statement of fluctuations in Net Debt provides an
overview of an organization’s net debt fluctuations during a specific period.
The Financial Accounting Standards Board (FASB) defines it as follows:- Six qualitative
factors determine the quality of financial information. They are relevance, faithful 37
representation, Comparability, Verifiability, and understandability.
UNIT 1
Understanding Financial
Statements
NOTES Comparative analysis involves comparing financial data for different periods to identify
trends, changes, and patterns in a company’s performance. Choose the periods for
comparison, which could be monthly, quarterly, or yearly financial statements. Compare
line items (e.g., revenue, expenses, net income) across the selected periods. Look for
increases, decreases, or consistency. Compute the percentage change for each line item
to understand the rate of growth or decline. Investigate significant variances and seek
explanations for the changes observed.
Common-size analysis involves expressing each line item on a financial statement as a
percentage of a base item. This allows for the comparison of different-sized companies
or different line items within the same company. Choose a base item for each financial
statement. Common choices include total revenue or total assets. Express each line item
as a percentage of the chosen base item. This is done by dividing the line item by the
base item and multiplying by 100. Examine the common-size percentages to identify
patterns and trends. This allows for a standardized comparison across different periods
or companies.
Trend analysis is a method used frequently to interpret any patterns in the data that
is being analyzed. Trend analysis in accounting involves the examination of financial
data over multiple periods to identify patterns, changes, and potential insights. It is a
valuable tool for assessing a company’s financial performance and making informed
decisions.
Cash Flow Analysis denotes the study of actual inflows and outflows of funds within a
company. Cash flows into the firm are known as positive cash flows or cash inflows, and
cash movements out of the business are known as negative cash flows or cash outflows.

1.12 KEYWORDS
Assets: The resources that a corporation owns and has economic value are called assets.
These can be either intangible (such as patents and trademarks) or tangible (such as cash,
property, and machinery).
Liabilities: Liabilities are termed as the company’s debts or commitments to other parties,
including accounts payable, loans, and other liabilities.
Current Assets: These are assets that are expected to be converted into cash or used up
within one year. Examples include cash, accounts receivable, and inventory.
Fixed Assets (or Non-Current Assets): These are long-term assets with a useful life of
more than one year. Examples include property, plant, equipment, and intangible assets
like patents and trademarks.
Cash and Cash Equivalents: This includes physical currency, bank balances, and short-
term investments that are easily convertible to cash.
Accounts Receivable: The money owed to the company by its customers for goods or
services sold on credit.
Inventory: The goods a company holds for the purpose of resale.
Current Liabilities: Obligations that are expected to be settled within one year. Examples
include accounts payable, short-term loans, and accrued expenses.
38 Long-Term Liabilities: Debts and other financial obligations that will not become due
within the next year. Examples include long-term loans and bonds.
 FINE005
Financial Analysis and
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Accounts Payable: Amounts owed by the company to its suppliers or vendors for goods NOTES
and services received on credit.
Accrued Liabilities: Liabilities that have been incurred but not yet paid. Examples include
accrued salaries and accrued interest.
Owner’s Equity (or Shareholders’ Equity): Represents the owners’ residual interest in
the assets of the company after deducting liabilities. It is the net assets of the company
and includes common stock, retained earnings, and additional paid-in capital. It can be
calculated by the difference between an organization’s assets and liabilities for a particular
period. Assets = liabilities is also called as accounting equation.
Retained Earnings: The cumulative amount of profits that have been retained in the
business rather than distributed to shareholders as dividends.
Sales Revenue: The total amount of money generated by the sale of goods or services
before any expenses are deducted.
Net Sales: Sales revenue minus any returns, allowances, and discounts.
Other Revenue: Income generated from sources other than the primary business activities,
such as interest, royalties, or fees.
Cost of Goods Sold (COGS): The direct costs associated with producing goods or services,
including materials, labor, and overhead.
Gross Profit: Net sales revenue minus the cost of goods sold. It represents the basic
profitability of the core business operations.
Operating Expenses: Costs incurred in the day-to-day operations of the business, including
selling, general, and administrative expenses (SG&A).
Depreciation and Amortization: Non-cash expenses that allocate the cost of long-term
assets over their useful life.
Interest Expense: The cost of borrowing money.
Income Tax Expense: The amount of income tax owed to the government based on the
company’s taxable income.
Operating Income (Operating Profit): Gross profit minus operating expenses. It reflects
the profitability of the company’s core operations.
Net Income (Net Profit or Net Earnings): The final amount after deducting all expenses,
including taxes, from the revenue. It represents the overall profitability of the company.
Earnings Before Interest and Taxes (EBIT): A measure of a company’s profitability before
considering interest and tax expenses.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): Similar to
EBIT but excludes depreciation and amortization. It provides a measure of operating
performance without accounting for non-cash expenses.

1.13 REFERENCES AND SUGGESTED ADDITIONAL READING

1. Narayanaswamy R. Financial Accounting: A Managerial Perspective. PHI Learning
Pvt. Ltd., Delhi.
39
2. Robert N. Anthony, David F. Hawkins, Kenneth A. Merchant. Accountancy-text and
cases. McGraw Hill Education (India) Private Limited, New Delhi.
UNIT 1
Understanding Financial
Statements
NOTES 3. Maheshwari S. N., Maheshwari Sunil K., and Maheshwari Sharad K, An Introduction
to Accountancy, Vikas Publishing House Pvt. Ltd., New Delhi.
4. https://zerodha.com/varsity/modules/
5. https://www.khanacademy.org/
6. https://corporatefinanceinstitute.com/
7. https://www.fasb.org/
8. https://www.sec.gov/

1.14 SELF-ASSESSMENT QUESTIONS

1. A financial statement that offers information about a company’s revenues, expenses,
and profits for a specific period is termed as?
(a) Balance Sheet
(b) Cash Flow Statement
(c) Income Statement
(d) Statement of Changes in Equity
2. What does the “Net Income” in the income statement represent?
(a) Total assets minus total liabilities
(b) Revenues minus expenses
(c) Total equity minus retained earnings
(d) Total cash inflow minus total cash outflow
3. Current assets are expected to be converted into cash or used up within:
(a) One month
(b) Three months
(c) Three to six months
(d) An year or less
4. Non-current assets are also known as:
(a) Liquid assets
(b) Fixed assets
(c) Current liabilities
(d) Current assets
5. Which financial statement shows the financial position of a company at a specific
point in time?
(a) Statement of Changes in Equity
(b) Income Statement

40
(c) Cash Flow Statement
(d) Balance Sheet
 FINE005
Financial Analysis and
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6. Total liabilities represent: NOTES
(a) The money a company owes to its shareholders
(b) The money a company owes to its suppliers
(c) The total expenses incurred by the company
(d) The total economic resources of the company
7. How “Gross Profit” is calculated in the income statement?
(a) Total Revenue – Total Expenses
(b) Total Revenue – Cost of Goods Sold (COGS)
(c) Total Revenue + Total Expenses
(d) Total Revenue + Cost of Goods Sold (COGS)
8. Which of the following items is classified as a non-current liability?
(a) Accounts Payable
(b) Long-term bank loan
(c) Salaries payable
(d) Short-term bank loan
9. Which financial statement is related about the cash inflows and outflows of a
company?
(a) Balance Sheet
(b) Cash Flow Statement
(c) Income Statement
(d) Statement of Changes in Equity
10. Intangible assets include:
(a) Buildings and machinery
(b) Cash and cash equivalents
(c) Trademarks and patents
(d) Inventories and accounts receivable

1.15 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. True
2. False
3. False
4. True
5. True 41
UNIT 1
Understanding Financial
Statements
NOTES Check Your Progress – II
1. True
2. True
3. False
4. False
5. True
Check Your Progress – III
1. True
2. True
3. False
Check Your Progress – IV
1. True
2. True
3. False
Check Your Progress – V
1. True
2. True
3. True
4. False
5. False

1.16 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (b) 3. (d) 4. (b) 5. (a)
6. (d) 7. (b) 8. (b) 9. (b) 10. (c)

42
 UNIT 2
FINANCIAL STATEMENTS ANALYSIS

STRUCTURE
2.0 Objectives
2.1 Introduction
2.2 Ratio Analysis
2.3 Types of Ratios
2.4 Liquidity Ratios
2.5 Solvency Ratios
2.6 Profitability Ratios
2.7 Efficiency Ratios
2.8 Valuation Ratios
2.9 DuPont Analysis
2.10 Let Us Sum Up
2.11 Keywords
2.12 References and Suggested Additional Readings
2.13 Self-Assessment Questions
2.14 Check Your Progress – Possible Answers
2.15 Answers to Self-Assessment Questions

2.0 OBJECTIVES
After reading this unit, you will be able to:
1. explain meaning and types of ratios.
2. discuss the significance and limitations of financial ratio analysis.
3. discuss the financial ratios and their applicability by businesses in decision
making.
4. calculate ratios and interpret them.
5. discuss the relationship among ratios using DuPont Analysis.

43
UNIT 2
Financial Statements Analysis
NOTES RECAP OF CHAPTER 1
In the previous section, we talked about the types of financial statements and the
objectives of these statements. These statements are of prime importance for various
stakeholders. The three core financial statements include the balance sheet, the income
statement and the cash flow statement. The Income Statement is also known as the Profit
and Loss Statement.
We now move ahead to cover another important topic, that is, the ratio analysis.
This section will cover all important ratios, and the need and benefits of analyzing
these ratios.

2.1 INTRODUCTION
Financial statement analysis is the process of analyzing a company’s financial statements
in order to make decisions. It is used by external stakeholders to evaluate an organization’s
overall health as well as its financial performance and economic value. It provides internal
constituents with a financial management monitoring tool.
Certain important considerations are core to the analysis of financial statements.
These include:
• As part of financial accounting, all organizations are required to create a balance
sheet, income statement, and cash flow statement. Financial statement analysis is
based on these documents.
• Three techniques are used by analysts to review financial statements: ratio analysis,
vertical analysis, and horizontal analysis.
• One of the main tasks of a financial analyst is to conduct a thorough examination
of a company’s financial accounts.
• The main goal of financial analysis is to measure a company’s financial performance
over time and in comparison, to its competitors This information can then be used
to forecast a corporation’s financials for the future.

2.2 RATIO ANALYSIS

Ratio analysis is a common and an important tool in financial statement analysis. It can
be understood as the quantitative analysis and interpretation of different numerical
proportions or ratios obtained from the financial statements of a business. These ratios are
used as indicators and benchmarks to evaluate various facets of a business’s operational
effectiveness, financial health, and performance. Analysts, investors, and managers can
get important insights about the company’s strengths, weaknesses, and overall financial
situation by evaluating and comparing these ratios over time, in comparison to industry
norms, or with other businesses.
Ratio analysis is essentially the process of transforming intricate financial data into an
organized style that enables insightful evaluations and comparisons. It offers a methodical
approach to assess the profitability, liquidity, solvency, efficiency, and other crucial financial
characteristics of a business. This technique is popular because it provides a standardized
way to comprehend a company’s financial situation and make informed decisions about
its performance and future prospects. It is utilized extensively in financial research, and
44 financial decision making.
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2.2.1 APPLICATION OF RATIO ANALYSIS NOTES
Ratio analysis is extensively used in different areas. It is an invaluable instrument for
evaluating the financial well-being of an organization, making wise business decisions,
and informing stakeholders about financial facts. The following are some important uses
for ratio analysis:
1. Assessment of Financial Performance: Ratio analysis is frequently employed to
evaluate the overall financial performance of a business. Analysts can assess a
company’s profitability by computing and comparing profitability ratios (such
as net profit margin and gross profit margin) over a period or in comparison to
industry averages.
2. Liquidity Assessment: Ratio analysis also helps to ascertain the capacity of a
company to meet its short-term financial obligations. This is done primarily with
the help of current ratio, quick ratio and cash ratio. These ratios are essential for
evaluating the company’s liquidity and its ability to control ongoing operating
costs.
3. Solvency and Long-Term Stability: A company’s long-term solvency and
capacity to pay off debt are shown by ratios such the debt-to-equity and
interest coverage ratios. Both creditors and investors should be aware of these
ratios.
4. Operational Efficiency: A firm needs to assess its efficiency in using its resources
and controlling its inventory. This is done with the help of efficiency ratios,
such as asset turnover ratio and inventory turnover ratio. Increased turnover
ratios are frequently a sign of efficient asset use.
5. Making Investment Decisions: Ratio analysis is a tool used by investors to
assess possible investments. An organization that exhibits robust profitability,
liquidity, and efficiency ratios could be perceived as a more appealing choice for
investment.
6. Creditworthiness Assessment: Prior to offering loans or credit facilities,
creditors and lenders evaluate a company’s creditworthiness using ratio
analysis. Strong ratios are a sign of improved repayment ability and decreased
risk.
7. Financial Forecasting and Budgeting: Ratio analysis helps with financial
forecasting and budgeting by offering benchmarks and historical trends that can
direct future financial estimates.
8. Mergers and Acquisitions: Ratio analysis is useful in assessing the financial
standing and potential synergies between businesses when contemplating
mergers, acquisitions, or partnerships.
9. Performance Benchmarking: Ratios make it easier to for a company to compare
its performance to that of its peers in the industry, and help identify areas for
development and keep a competitive edge.
10. Management Evaluation: Ratio analysis sheds light on how well a company’s
management employs strategies and makes use of available resources in order
to meet its financial objectives. 45
UNIT 2
Financial Statements Analysis
NOTES 11. Communication: Ratios provide a consistent means of informing different
stakeholders—including analysts, shareholders, board members, and regulators—
about financial performance.
12. Identifying Financial Red Flags: Unfavorable ratio changes may point to fundamental
problems with money, such as falling profitability or high debt that needs immediate
attention necessitating additional research and remedial measures. These indicators
are brought to the notice of the relevant authorities by raising a red flag which
means that the information requires attention otherwise, this may adversely impact
the company.
To sum up, ratio analysis is a versatile technique that supports effective internal and
external communication inside businesses as well as decision-making and financial health
evaluation. Ratio analysis needs to be combined with qualitative analysis and a thorough
grasp of the business environment to produce an accurate and perceptive interpretation.

2.2.2 BENEFITS AND DRAWBACKS OF RATIO ANALYSIS

Ratio analysis is a useful tool in financial analysis; however, it has its share of pros and cons
as well. Let us look into the advantages and disadvantages associated with ratio analysis.
Advantages of Ratio Analysis
• Aids in establishing links and simplifying complicated figures
Ratios are useful for analysing and determining the links between complicated
accounting statistics. These help to understand the given financial data in a simple
and easy manner.
• Facilitates comparative analysis
Ratios help to draw an effective comparison between the specified objective and
the final outcome. These further give us a clear picture of whether things are going
as expected or not. A business’s profitability, liquidity, and other components can
be compared as follows:
– For accounting with itself
– In cooperation with other companies
– Adhering to the standards of the company or sector
• Shows effectiveness
Ratios that may be used to assess how well a business is using its assets and
resources to generate sales or decrease inventory include inventory turnover and
sales turnover ratios. Greater ratios suggest a more efficient business; declining
ratios over time may point to a number of issues, including excess inventory, an
item that is getting outdated, or a poor marketing or sales plan.
• Ascertains solvency
When assessing if a company’s assets are adequate to support its short- and long-
term existence, analysing and measuring solvency ratios might be helpful.
• Establishes Liquidity
Ratio analysis shows how much cash a company has on hand and may be used
46 to estimate how much cash the company might quickly raise in the event of an
unanticipated emergency. Conversely, a big investment in liquid assets might mean
 FINE005
Financial Analysis and
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that the company is passing on greater profits on less liquid securities. Therefore, NOTES
it is desirable to have the right level of liquidity.
• Shows the state of the market
If a company is overpriced or undervalued in relation to its peers, ratios can be
used to assess this. Thus, it helps management decide what kind of long-term
strategy to follow and how a company’s success corresponds to its share value.
Additionally, it aids investors in deciding whether to purchase the stock given the
level of risk at that time.
• Evaluates profit
Ratios help evaluate a company’s investment potential. When a company’s gross
profit margin exceeds its net profit margin, it suggests that its expenses are above
average and that it should examine them to determine where it can make savings.
• Helps with strategic planning
After reviewing the ratios, management may go on with strategic planning, including
activities linked to capital growth or leasing as an alternative to purchasing a fixed
asset. Through the integration of data and future market estimates, management
may create a long-term expansion strategy that can be gradually implemented.
• Establishes budgetary planning
Ratio analysis is used to plan operating costs as well as other yearly expenses and
investments. For instance, if an organization’s inventory turnover ratio is extremely
high, it may be able to cut ordering costs by placing big orders and building up
inventory, provided that demand estimates remain unchanged.
After having an insight into the advantages of ratio analysis, we will now assess certain
disadvantages or limitations of ratio analysis:
Disadvantages and Limitations of Ratio Analysis
(i) Narrow focus: Ratios only offer a quick overview of a business’s financial
performance; they might not fully convey the complexities of its business
practices or the dynamics of the industry.
(ii) Manipulation possibility: Businesses may alter ratios by manipulating their
financial accounts, which could result in errors or incorrect interpretations.
(iii) Industry variations: Since different industries have different standards and
procedures, it can occasionally be difficult to compare ratios directly. Ratios of
firms operating in different industries are, therefore, not comparable.
(iv) Data restrictions: Ratios are calculated using past financial data, which may
not accurately represent the situation of the market now or modifications to
corporate strategies.
(v) Lack of context: Ratios do not include the background information about the
numbers, including the causes of ratio changes and the effects of outside influences.
(vi) Ignores qualitative elements: Ratio analysis considers only the numerical figures
and tends to ignore qualitative elements that affect financial performance in
favor of quantitative data.
In short, ratio analysis is a powerful tool that offers valuable insights into a company’s 47
financial performance and health. However, it should be used judiciously, considering
UNIT 2
Financial Statements Analysis
NOTES its limitations and complementing it with qualitative analysis for a more comprehensive
understanding of a company’s situation.

CHECK YOUR PROGRESS – I

1. A financial technique called ratio analysis is used to evaluate a company’s
performance and stability.
(a) True
(b) false
2. A company’s short-term liquidity and capacity to settle its current liabilities are
gauged by the current ratio.
(a) True
(b) false
3. Profitability ratios evaluate how well a business uses its resources to produce revenue.
(a) True
(b) false
4. Ratios are independent measurements that don’t need to be compared to other
measures or benchmarked.
(a) True
(b) false
5. Ratio analysis uses qualitative and quantitative data for analysis.
(a) True
(b) false

2.3 TYPES OF RATIOS

So far, we have realized that ratio analysis helps to gain meaningful insights about the
performance and financial health of a company. Let us now get an understanding about
the various types of ratios primarily used for making an analysis.
The types of ratios include:
1. Liquidity Ratios: These ratios evaluate a business’s capacity to pay short-term
debts. They shed light on the company’s liquidity situation and ability to pay off
short-term debt with its present assets.
2. Solvency Ratios: These ratios assess the long-term financial stability and
debt-service capacity of an organization. The financial risk and leverage of the
company are shown by these ratios.
3. Profitability Ratios: These ratios assess how profitable a business is in relation
to its equity, revenue, and assets. These ratios are essential for determining how
well a business uses its resources to produce returns.
4. Efficiency Ratios: These ratios show the effectiveness with which a business
48 manages its inventory, assets, and other resources to produce sales and income.
Operational effectiveness is reflected in these ratios.
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5. Market Ratios: From the viewpoint of an investor, market ratios shed light on a NOTES
company’s performance. They contrast the market price of the business with its
dividends, book value, or earnings.
Each kind of ratio gives a different viewpoint on the financial performance of a business,
giving decision-makers a wide range of analytical tools. The goals of the analysis and the
background of the industry, influences the careful selection and interpretation of pertinent
ratios. Analysts, investors, and other stakeholders can better comprehend a company’s
financial situation and make well-informed decisions by combining these ratios.
Given below are the most widely used ratios used by firms to assess financial performance
and make daily choices.

Table 2.1: Types of Ratios

Category of Description Category-wise Ratios

Ratios
Liquidity Assess a company’s capacity to •
Current Ratio
Ratios use its short-term assets to pay •
Quick Ratio
its short-term debt. •
Cash Ratio
Solvency Evaluate a company’s capacity to • Debt-to-Equity Ratio
Ratios fulfill long-term commitments and •Debt Ratio
its long-term financial stability. •
Interest Coverage Ratio
Profitability Analyze a company’s profitability •Gross Profit Margin
Ratios in relation to equity, assets, or •
Net Profit Margin
sales. •
Return on Equity
•
Operating Profit Margin
•
Return on Assets
•
Earnings Per Share (EPS)
Efficiency Analyze how well a business •
Asset Turnover Ratio
Ratios uses its resources to produce •
Inventory Turnover Ratio
income or sales. •
Accounts Receivable Turnover Ratio
•
Accounts Payable Turnover Ratio
•
Operating Cycle
•
Days Sales Outstanding
Market Give an investor’s perspective •
Price-to-Earnings Ratio
Ratios/ by relating a company’s market • Price-to-Book Ratio
Valuation price to its earnings, book value, •
Price-to-Sales (P/S) Ratio
Ratios or dividends.
•
Enterprise Value-to-EBITDA (EV/
EBITDA) Ratio
• Dividend Yield
DuPont To better understand the factors • Dupont ROE Formula
Analysis that drive profitability, break
down return on equity (ROE)
into its constituent parts.
49
Source: Compiled by author
UNIT 2
Financial Statements Analysis
NOTES Table 2.1 provides a concise overview of the various types of ratios and some specific
ratios within each category. Remember that the selection of a particular ratio depends on
the objectives of the analysis and the business the company belongs to.

2.4 LIQUIDITY RATIOS

Liquidity is the capacity of a company to pay its short-term debts. Liquidity ratios offer valuable
insights about a company’s short-term financial health and its ability to handle daily operations
without taking dramatic actions, which are crucial in the fast-paced world of business.
Fundamentally, liquidity ratios answer queries such as: Is the corporation able to easily
pay its short-term debts? Does it have sufficient liquid assets to cover unforeseen costs
or downturns in the economy? To preserve operational continuity and financial stability,
the company’s liquidity position must be clearly understood by creditors, investors, and
management teams. These ratios assist in achieving this goal.
A firm’s financial liquidity is shown by important liquidity ratios such as the current ratio,
quick ratio (sometimes called the acid-test ratio), and cash ratio. These ratios show how
well a company can handle short-term financial difficulties without risking its ongoing
operations. As you learn more about liquidity ratios, you’ll see how they can provide
insightful information about a company’s risk appetite, working capital management
skills, and financial flexibility.
1. Current Ratio
A financial ratio called the current ratio assesses how well a business can use its
short-term assets to pay off its short-term liabilities. It sheds light on whether a
business has the liquid assets enough to pay its short-term debts that are coming
due in less than a year. The following formula can be used to get the current ratio:

Current Ratio = Current Assets/Current Liabilities

where:
Assets that are anticipated to be used up or converted into cash within the upcoming
operational cycle (usually one year) are referred to as current assets. This can include
short-term investments, cash, inventories, and accounts receivable.
Current liabilities include debts like accounts payable, short-term loans, and other short-
term obligations that the business must pay off during the next operational cycle.
How many times a company’s current assets can cover its current obligations is
shown by its current ratio. More current assets than current liabilities are indicated
by a current ratio above 1, which is typically regarded as an indication of liquidity
that the business is well-positioned. On the other hand, an excessively high current
ratio may suggest that the business has too many idle assets and might be making
better use of its resources.
Below is the Illustration to understand liquidity ratios in detail:
For instance, Company XYZ’s financial data for the most recent fiscal year in INR is
as follows:
• Current Assets: I5,00,000
50 • Current Liabilities: I3,00,000
 FINE005
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Solution: NOTES
Current Ratio = Current Assets/Current Liabilities

Current Ratio = I5,00,000/I3,00,000 = 1.67

The current ratio of 1.67 indicates that Company XYZ has I1.67 in current assets for
every I1 of current liabilities.
Interpretation and Corporate Applicability of Current Ratio:
The current ratio is a tool used by analysts, creditors, and investors to evaluate a
company’s liquidity and short-term debt management. It is noteworthy that although
a high current ratio could indicate strong liquidity, it does not offer a comprehensive
view of a company’s financial well-being.
2. Quick Ratio (Acid-Test Ratio)
The Quick Ratio, sometimes referred to as the Acid-Test Ratio, is a financial ratio
that evaluates how well a business can use its most liquid assets to pay off its
short-term debt. The Quick Ratio does not include inventory, in contrast to the
Current Ratio, because inventory may not be readily convertible to cash in the near
future. This ratio offers a more cautious assessment of a business’s liquidity and
ability to pay short-term debts. To find the Quick Ratio, use this formula:
Quick Ratio = (Current Assets – Inventory-Deferred or Prepaid Expenses)/
Current Liabilities
Where:
Assets such as cash, accounts receivable, and short-term investments that can be
easily turned into cash during the following operating cycle (usually one year) are
referred to as current assets.
The term “inventory” describes the commodities or products that a business possesses
and plans to sell. Inventory is not included in the computation because it could take
some time to sell and turn a profit.
Current liabilities include debts that must be paid off by the business in the upcoming
cycle of operations, like accounts payable and short-term loans.
Deferred expenses also known as prepaid expenses represent the costs which
are already incurred for unconsumed or unutilized services. In other words,
the expenses or costs not due but paid in advance. Therefore, they cannot
be reported on the current Profit and Loss statement, or Income Statement,
since the payments are effectively meant for the future uses of the products or
services. In view of this, it is necessary that these expenses must be deferred
on the company’s balance sheet until the time they become due for payment.
These expenses are shown in the credit side of Profit & Loss account and on the
assets side of the balance Sheet so as to reflect the true position of profits and
assets and liabilities. We can think of a simple example of advance rent paid for
the next 6 months
A company’s capacity to satisfy its short-term financial obligations without
depending on the sale of inventory can be determined by looking at its Quick
Ratio. A quick ratio of one or more is usually seen as good since it shows that 51
UNIT 2
Financial Statements Analysis
NOTES the business has enough highly liquid assets to pay for its immediate liabilities.
A Quick Ratio that is noticeably higher than 1, however, can indicate that the
business is hoarding too much liquid assets that could be used for more profitable
investments.
For instance, consider Company XYZ with the following financial data:
• Current Assets: I500,000
• Inventory: I100,000
• Current Liabilities: I300,000

Solution:

Quick Ratio = (Current Assets − Inventory)/Current Liabilities

Quick Ratio = (I500,000 − I100,000)/I300,000 = 1.33

The quick ratio of 1.33 indicates that Company XYZ has I1.33 in highly liquid assets
(excluding inventory) for every I1 of current liabilities. This suggests a reasonable
level of liquidity and the ability to meet short-term obligations even without
considering inventory sales.
Interpretation and Corporate Applicability of Quick Ratio
A useful metric for evaluating a company’s current liquidity status and ability to
manage unforeseen financial difficulties is the Quick Ratio.
3. Cash Ratio
A financial measure called the cash ratio assesses whether a business can meet
its short-term obligations with just cash and cash equivalents. The Cash Ratio
only considers a company’s most liquid resources, in contrast to the Current
Ratio and Quick Ratio, which also consider different kinds of current assets.
This ratio offers a strict gauge of liquidity since it evaluates the company’s ability
to meet short-term financial obligations without depending on other assets like
inventories or accounts receivable. The following formula can be used to get the
cash ratio:

Cash Ratio = Cash and Cash Equivalents/Current Liabilities

Where:
Both real cash on hand and highly liquid investments that can be quickly converted
into cash are included in the term “cash and cash equivalents.”
Current liabilities include debts like accounts payable, short-term loans, and other
short-term obligations that the business must pay off during the next operational
cycle.
How successfully a business can satisfy its short-term obligations using just its most
easily accessible financial resources is demonstrated by the cash ratio. A cash ratio
greater than one indicates that the business has enough cash on hand to pay down
its current debts and maintains backup to meet unforeseen expenses. On the other
hand, a too high cash ratio can mean that the business has extra cash on hand that
52 would be better spent or invested somewhere else.
 FINE005
Financial Analysis and
Business Valuation
For example, consider Company ABC with the following financial data: NOTES
• Cash and Cash Equivalents: I150,000
• Current Liabilities: I300,000
Solution:

Cash Ratio = Cash and Cash Equivalents/Current Liabilities

Cash Ratio = I150,000/I300,000 = 0.5

The cash ratio of 0.5 suggests that Company ABC has I0.50 in cash and cash
equivalents for every I1 of current liabilities. This demonstrates the company’s
immediate cash position and its ability to settle obligations with available funds.
Interpretation and Corporate Applicability of Cash Ratio
Cash ratio depicts the ability of a business to meet its short-term obligations using
only cash and cash equivalents. A cash ratio greater than one indicates that the
business has enough cash on hand to pay down its current debts and maintains
backup to meet unforeseen expenses. On the other hand, a too high cash ratio
can mean that the business has extra cash on hand that would be better spent or
invested somewhere else. However, there is no ideal figure, but a ratio of at least 0.5
to 1 is generally assumed to be more appropriate.

2.5 SOLVENCY RATIOS

Financial measures called solvency ratios—also referred to as leverage ratios, capital
ratios, or gearing ratios—offer information on a company’s capacity to pay off its long-
term debts and commitments. These ratios evaluate the overall financial well-being and
long-term viability of a business. Solvency ratios are a common tool used by analysts,
investors, and lenders to assess a company’s creditworthiness and stability.
1. Debt-to-Equity Ratio (D/E)
A financial ratio called the debt-to-equity ratio (D/E) expresses how much of a
company’s entire debt is compared to its total equity. It’s employed to evaluate the
leverage of the business, or how much of it depends on debt funding as opposed to
equity financing. Greater debt to equity is indicated by a greater D/E ratio, which can
raise financial risk and make it more difficult to pay off debt.
The formula for calculating the Debt-to-Equity Ratio is:
D/E = Total Debt/Total Equity​
Equity represents the value that shareholders held in the company. The book value
of equity is arrived as the difference between assets and liabilities according to the
company’s balance sheets. The debt refers to the capital or funds that a company
owes to outsiders. It is an obligation for a company to be met within a given
time. It carries an interest on the debt component. Under the debts, the interest-
bearing short term and long-term loans are the liabilities of the banks and financial
institutions. It also includes all fixed payment obligations.
The remaining stake in the business’s assets after liabilities have been subtracted
is known as total equity. It symbolizes the ownership of the business by the
shareholders. 53
UNIT 2
Financial Statements Analysis
NOTES For instance, a company’s entire debt is I6000 million, but its total equity is I9000
million. Determine the ratio of debt to equity.
Solution:
• Total Debt: I6000 million
• Total Equity: I9000 million
D/E = Total Debt/Total Equity​
D/E = 6000/9000 = 0.67

In this scenario, the company has a Debt-to-Equity Ratio of 0.67, indicating that for
every 1 INR of equity, it has 0.67 INR of debt.
Interpretation and Corporate Applicability of the Debt-to-Equity Ratio:
• A low D/E ratio (below 1) suggests that the company relies more on equity
financing, which is generally considered less risky.
• A high D/E ratio (above 1) indicates a significant reliance on debt financing,
which can amplify returns during good times but also increase financial risk
and interest expenses during challenging times.
• Extremely high D/E ratios might imply that the company is heavily leveraged
and may struggle with debt repayment.
It’s important to note that the optimal level of debt varies by industry and
company circumstances. Comparing D/E ratios across industries should be done
with caution, as different industries have different norms due to varying capital
requirements and risk profiles.
2. Debt Ratio
A financial indicator called the debt ratio indicates what percentage of an organization’s
total assets are financed by debt. It sheds light on how much a business depends
on borrowing money to maintain its operations and developments. The Debt Ratio
evaluates the company’s exposure to credit risk and aids in the understanding of the
financial leverage of the business by creditors, investors, and analysts.
The Debt Ratio can be computed mathematically as follows:

Debt Ratio = Total Debt/Total Assets

where:
The total of the company’s short-and long-term debt obligations is known as its total
debt.
The value of all the assets that the company owns is represented by the term Total
Assets.
Example Let us assume that a small Bakery unit owns total assets of Rs. 5,00,000 and
total debt of Rs. 2,00,000, the debt ratio in this case will be;

Total Debt/Total assets

= 2,00,000/5,00,000
54 = 0.4 orc 40%
 FINE005
Financial Analysis and
Business Valuation
A lower debt ratio of 0.4 expresses that the company is in a good standing position NOTES
to pay its debt obligations
Interpretation and Corporate Applicability of the Debt Ratio:
• A higher debt ratio denotes a greater reliance on borrowed funds, which could
increase financial risk and make the company more susceptible to interest rate
fluctuations or economic downturns.
• A lower debt ratio suggests that the company relies less on debt financing and
has a lower risk of financial distress due to its debt obligations.
The Debt Ratio should be interpreted with consideration for the business style,
company size, and industry norms. Comparing different industries should be done
with caution since different businesses may have different acceptable ranges for
debt ratios.
3. Interest Coverage Ratio
The Interest Coverage Ratio is a financial indicator to assess how well a business can
use its operational profits to pay its interest costs. It shows how much a company’s
earnings can cover its interest costs, indicating how well-equipped it is to pay off
debt. A high interest coverage ratio is an indicator of a better financial standing and
a decreased chance of defaulting on interest payments.
The formula for calculating the Interest Coverage Ratio is:

Interest Coverage Ratio = Operating Earnings/Interest Expenses

where:
Operating Earnings represent a company’s earnings before interest and taxes (EBIT).
Interest Expenses are the costs associated with servicing the company’s debt.
To illustrate, a company has I3000 million Operating Earnings and I500 million as
Interest Expenses. Calculate the Interest Coverage Ratio.
Solution:

• Operating Earnings: I3000 million

• Interest Expenses: I500 million

Interest Coverage Ratio = Operating Earnings/Interest Expenses

Interest Coverage Ratio = 3000/500 = 6

In the above example, the Interest Coverage Ratio is 6, which means that the
company’s operating earnings are six times its interest expenses. The ratio is read
in terms of ‘times’. This indicates that the company has a relatively strong ability to
meet its interest payments from its operating income.
In general, a high interest coverage ratio indicates that a business has enough
earnings to meet its interest payments even during difficult times. Nevertheless, the
definition of a “good” or “safe” ratio might differ depending on the sector, size of the
organization, and state of the economy. 55
UNIT 2
Financial Statements Analysis
NOTES 2.6 PROFITABILITY RATIOS
Financial measurements known as profitability ratios evaluate a company’s capacity to
earn a profit in relation to its various revenue, asset, equity, and other financial component
levels. These statistics shed light on how well a business manages its resources and
operations to earn a profit. When assessing a company’s overall financial performance
and capacity to generate value for shareholders, profitability ratios are essential.
1. Gross Profit Margin
Gross Profit Margin(GPM), as a financial indicator, calculates the portion of a
business’s revenue that is left over after subtracting the cost of goods sold (COGS).
It shows how profitable a business is at its main activities, which are the creation or
delivery of goods and services. GPM measures how well a business can create its
goods while meeting the direct expenses involved in doing so.
The formula for calculating the Gross Profit Margin is:

Gross Profit Margin = (Gross Profit/Revenue) × 100

where:
The difference between revenue (sales) and cost of goods sold (COGS) is used to
compute gross profit.
Revenue is the entire number of sales or income the business makes.
For instance, during the fiscal year, Company ABC, an Indian business, brought
in I10,000 million in sales, but its cost of goods sold (COGS) was I6,000 million.
Determine the Gross Profit Margin for ABC Company and explain the outcome.
Solution:
Given the following figures:
• Revenue: I10,000 million
• COGS: I6,000 million

Gross Profit Margin = Gross Profit/Revenue × 100

Gross Profit = Revenue − COGS

Plugging in the values:

Gross Profit = 10,000 − 6,000 = 4,000 million
Now, calculating the Gross Profit Margin:
Gross Profit Margin = 4,000/10,000 × 100 = 40%
I​ nterpretation of Example
Company ABC’s gross profit margin in this instance is 40%. This indicates that after
deducting the cost of items supplied, the business keeps 40 paise as gross profit
for every rupee of revenue. The efficiency with which the business produces its
goods or services is shown by the gross profit margin. A greater gross profit margin
typically indicates that the business is controlling its production costs well, which
56
puts it in a stronger position to pay other operating expenditures and turn a profit.
 FINE005
Financial Analysis and
Business Valuation
When assessing the outcome, it’s crucial to take industry benchmarks and trends NOTES
into account because the ideal level of gross profit margin can differ depending on
the industry.
Interpretation and Corporate Applicability of Gross Profit Margin:
The gross profit margin is one of the important measures to indicate the profitability
to understand and assess as how efficiently a business runs its manufacturing of
goods or services operations and how profitable it can make money before taking
other costs into account. The following could be interpreted.
• A lower GPM could imply that production costs are relatively high, which
could have an influence on profitability and call for more research into cost
management.
• A higher GPM shows that the company successfully manages its production
costs and makes a higher profit from its core operations.
• Due to variations in cost structures, market dynamics, and production techniques,
GPM varies significantly across industries. Comparing GPM within the same
industry or area is therefore crucial.

2. Operating Profit Margin (OPM)

Another important financial indicator is the operating profit margin (OPM) that
gauges how profitable a business is at its core operations. It shows the portion of
every rupee of revenue that is left over as operating profit following the subtraction
of operating expenses and cost of goods sold (COGS). Before deducting interest,
taxes, and non-operating expenses, a company’s capacity to make money from its
core business operations is shown by its operational profit margin (OPM). The OPM
formula is:

OPM = (Operating Profit/Total Revenue) × 100

Where Operating Profit is calculated as:

Operating Profit = Total Revenue − COGS − Operating Expenses
Let’s consider ABC Electronics Inc. again, and assume the following financial data for
the year 2022:
• Total Revenue: I3,50,00,000
• Cost of Goods Sold (COGS): I1,75,00,000
• Operating Expenses: I70,00,000

Solution:
OPM = (Operating Profit/Total Revenue) × 100

1. Calculate Operating Profit

Operating Profit = I3,50,00,000 − I1,75,00,000 − I70,00,000 = I1,05,00,000
2. Calculate Operating Profit Margin

OPM = (I1,05,00,000/I3,50,00,000) × 100 = 30% 57

UNIT 2
Financial Statements Analysis
NOTES Interpretation of example:
The Operating Profit Margin (OPM) of ABC Electronics Inc. in this case is roughly
30% in Indian Rupees. This indicates that, after deducting operational expenses and
cost of goods sold (COGS), the company keeps about 30 paise, or 0.30 INR, for every
rupee of income it generates.
Interpretation and Corporate Applicability of Operating Profit Margin (OPM):
• In general, a higher OPM denotes the profitability and efficiency of the company’s
key business operations. It implies that the business is handling its operational and
manufacturing costs well, which is encouraging to stakeholders and investors.
• Additional information on the operational effectiveness of the business may be
obtained by comparing the OPM to industry benchmarks and the company’s
past performance. To gain a complete picture of the company’s total financial
success and health, it’s crucial to take OPM into account in addition to other
financial parameters.

3. Net Profit Margin (NPM)

The percentage of a company’s revenue that is left over as net profit, after all
expenditures, such as operating expenses, interest, taxes, and other non-operational
costs, have been subtracted is known as net profit margin, or NPM. After deducting
all operating and finance expenses, NPM offers a comprehensive picture of a
business’s profitability.
The formula for calculating the Net Profit Margin is:

Net Profit Margin = (Net Income/Revenue) × 100

Where:
Net Income is the company’s total earnings after all expenses have been deducted,
including operating expenses, interest, taxes, and other costs.
Revenue represents the total sales or revenue generated by the company.
Let’s consider a company named ABC Electronics Inc. The company’s financial data
for the year 2022 is as follows:
• Total Revenue: I3,50,00,000
• Cost of Goods Sold (COGS): I1,75,00,000
• Operating Expenses: I70,00,000
• Interest Expenses: I7,00,000
• Tax Expenses: I21,00,000

Calculate Net Profit Margin.

Solution:

Net Profit Margin = (Net Profit/Total Revenue) × 100

Where Net Profit is calculated as:

58 Net Profit = Total Revenue − COGS − Operating Expenses − Interest Expenses − Tax
Expenses
 FINE005
Financial Analysis and
Business Valuation
Let’s calculate step by step: NOTES
Calculate Net Profit:

Net Profit = I3,50,00,000 − I1,75,00,000 − I70,00,000 − I7,00,000 − I21,00,000

= I76,00,000

Calculate Net Profit Margin:

NPM = (I76,00,000/I3,50,00,000) × 100 = 21.71%

Interpretation of example:
The Net Profit Margin of ABC Electronics Inc. in this scenario is roughly 22%.
This indicates that after subtracting all costs, such as the cost of goods sold,
operational expenditures, interest expenses, and tax expenses, the corporation keeps
roughly Rs. 22 for every Rs. 100 of revenue. A higher net profit margin shows that
the business is managing costs and expenses in relation to income well. Conversely,
a lower net profit margin could mean that the business is having trouble keeping
costs under control or that it is in a cutthroat sector where profit margins are thin.
Interpretation and Corporate Applicability of Net Profit Margin Ratio:
• A greater net profit margin (NPM) indicates that the business is managing
its operating expenses and other financial commitments well, which boosts
operational profitability.
• A decreased NPM can be a sign that the business is having trouble keeping
costs under control or that taxes and interest are having an impact.
• Understanding the relative profitability of various industries can be aided by
comparing NPM across companies or industries.
• Because it accounts for financial commitments, taxes, and operating expenses
in addition to operating costs, net profit margin provides a thorough
understanding of a business’s entire profitability. It’s a crucial indicator for
creditors, investors, and analysts to evaluate a business’s capacity to turn a
profit and efficiently control its spending.

4. Return on Equity (ROE)

Return on Equity (ROE) as a financial indicator, gauges a business’s profitability in
relation to the equity held by its shareholders. It demonstrates the effectiveness
with which a business returns on the capital invested by its owners. The following is
the formula for ROE:
ROE = (Net Income/Shareholders′ Equity) × 100
Where
Net Income is the company’s profit after deducting all expenses, and Shareholders’
Equity represents the amount of money invested by the shareholders.
Let’s consider ABC Electronics Inc. again and assume that its Net Income for the year
2022 is I76,00,000 and the Shareholders’ Equity is I3,00,00,000.
Solution:
• Net Income = I76,00,000 59

• Shareholders’ Equity = I3,00,00,000

UNIT 2
Financial Statements Analysis
NOTES ROE = (Net Income/Shareholders′ Equity) × 100

ROE = (I76,00,000/I3,00,00,000) × 100 ≈ 25.33%

Interpretation of example:
In this example, ABC Electronics Inc. has a Return on Equity (ROE) of approximately
25.33% in terms of Indian Rupees. This means that for every rupee invested by the
company’s shareholders, the company generates a profit of around 25.33 paise
(or 0.2533 INR).
Interpretation and Corporate Applicability of ROE:
• A greater return on equity (ROE) is usually regarded as a good sign since it
shows that the business is making effective use of its equity capital to produce
profits. It implies that the business is successfully allocating its resources and
managing its activities to maximize value for its owners.
• But it’s crucial to consider the industry and the business strategy of the
organization when interpreting ROE. Certain industries have inherent
differences in ROE based on risk and capital requirements. Further
information about the company’s financial performance may be obtained
by comparing its return on equity (ROE) to that of its rivals and past
performance.
• To sum up, a high return on equity (ROE) indicates excellent profitability in
relation to equity investment.

5. Return on Assets (ROA)

Next we have another important financial indicator, which is return on assets (ROA).
It gauges how profitable a business can make use of all of its assets. It shows how
well a business generates profits from its assets. The ROA Calculation is:

ROA = (Net Income + [Interest Expense × (1 − Tax Rate)])/Total Assets

where Total Assets is the total worth of all the assets the company owns, and Net
Income is the profit after all expenses are subtracted.
Let’s consider ABC Electronics Inc. again, and assume the following financial data for
the year 2022:
• Net Income: I76,00,000
• Total Assets: I5,00,00,000
• Interest Expense: I50,000
• Tax Rate: 50%

Calculate ROA.
Solution:
ROA = (Net Income + [Interest Expense × (1 − Tax Rate)])/Total Assets
= (76,00,000 + [50,000 (1-50%)])/5,00,00,000
= (76,00,000 + [50,000 × 50/100])/5,00,00,000
60 = (76,00,000 + 25,000)/5,00,00,000
 FINE005
Financial Analysis and
Business Valuation
= 76,25,000/5,00,00,000 NOTES
= 15.25%

Interpretation of the example:

In this case, ABC Electronics Inc.’s Return on Assets (ROA) in Indian Rupees is roughly
15.25%. This indicates that the corporation makes about Rs. 15.25 in profit for every
Rs. 100 of assets it owns. A greater ROA shows that the business is making good use
of its resources to produce revenue.
Interpretation and Corporate Applicability of Return on Assets (ROA):
• ROA gauges how well a business generates profits from its assets. Improved
asset utilization and efficient resource management are indicated by a greater
ROA. For better understanding:
• High ROA: A high ROA indicates that the business is making good use of its assets
to generate earnings. This could be the result of resource utilization, capital
allocation that is wise, and operations that are efficient.
• Low ROA: Inefficient use of assets may be indicated by a low ROA. It could imply
that the business isn’t making enough money off its asset investments. Poor
operational performance, exorbitant costs, or unused resources could be the
cause of this.
For a more accurate understanding, it is crucial to compare a company’s ROA to
peers in the industry and to its previous performance.
6. Earnings Per Share (EPS)
Earnings per Share (EPS) shows how much of a company’s profit is distributed to each
outstanding share of its ordinary stock. As a measure of the company’s profitability
per share, it is significant to shareholders. The EPS formula is:
EPS = Net Income − Preferred Dividends/Weighted Average Number of
Common Shares
​Net Income is the company’s profit after all costs are subtracted,
Before going for preference dividend, let us understand the preference shares.
The preference shares also known as preferred stock are the shareholders who
receive preference in getting dividend payment over the ordinary equity shareholders.
These shareholders also get preference over ordinary shareholders in getting payments
in case a company winds up. Therefore, preferred Dividends are dividends paid to
preferred shareholders.
Weighted Average Number of Common Shares is the average number of shares
outstanding over the course of a certain period.
Assume for the purposes of this analysis that ABC Electronics Inc. had I76,00,000 in
net income, I4,00,000 in preferred dividends, and an average of 1,00,000 outstanding
common shares in 2022.
Solution:

EPS = (Net Income − Preferred Dividends)/Weighted Average Outstanding

Number of Shares 61
UNIT 2
Financial Statements Analysis
NOTES • Net Income = I76,00,000
• Preferred Dividends = I4,00,000
• Average Common Shares Outstanding = 1,00,000

Therefore,

EPS = (I76,00,000 − I4,00,000)/1,00,000 = I72

Interpretation of example:
For instance, ABC Electronics Inc.’s earnings per share (EPS) in Indian Rupees is
I72. This indicates that the corporation earned I72 for each equity share owned
by shareholders. When evaluating a company’s profitability per share, investors
should consider earnings per share (EPS). This metric can be used to compare the
performance of other companies and guide investment decisions.
Interpretation and Corporate Applicability of Earnings Per Share (EPS):
The amount of profit allotted to each outstanding share equity share is measured by
EPS. It’s a crucial indicator for investors to assess the profitability of the business per
share. EPS can be interpreted as follows:
• High EPS: A company with a high EPS is often producing significant earnings per
share, which is good news for shareholders. Strong profitability, efficient cost
control, and possibly share buybacks could be the cause of this.
• Low EPS: A low EPS indicates that the company’s earnings per share are not
noteworthy. This could be the result of factors affecting profitability, a rise in
the number of outstanding shares, or fewer profits.
It’s critical to evaluate EPS in light of other aspects of the business, like its growth
potential, dividend policy, and the state of the market. Investors may find a firm with
a lower EPS but more growth potential to be appealing, particularly if the company’s
expansion can result in higher EPS and future earnings growth.

CHECK YOUR PROGRESS – II

1. Profitability ratios evaluate how well a business uses its resources to produce
revenue.
(a) True
(b) False
2. A high EPS indicates that the earnings per share is low, and the company has growth
potential.
(a) True
(b) False
3. When calculating a company’s liquidity, the quick ratio takes inventories into
account.
(a) True
(b) False
62
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Financial Analysis and
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4. A company’s short-term liquidity and capacity to settle its current liabilities are NOTES
gauged by the current ratio.
(a) True
(b) False
5. A corporation that has a higher debt-to-equity ratio is less dependent on debt
funding.
(a) True
(b) False
6. Ratio analysis is a useful tool for determining a stock’s intrinsic value.
(a) True
(b) False

2.7 EFFICIENCY RATIOS

Efficiency ratios evaluate how successfully a business uses its resources to generate income
and profits. They are sometimes referred to as activity ratios or asset utilization ratios.
These ratios shed light on the effectiveness of the company’s asset utilization, operational
efficiency, and liability management. Analysts, creditors, and investors frequently utilize
efficiency ratios to assess the performance and financial standing of a business.
1. Inventory Turnover Ratio: This ratio calculates the frequency with which a business
sells and replaces its inventory over a given time frame, usually a year. It shows how
well a business sells and maintains its inventory. The Inventory Turnover Ratio is
calculated as follows:

Inventory Turnover Ratio = Cost of Goods Sold/Average Value of Inventory

where,
Cost of Goods Sold (COGS) is the total cost of producing goods sold during the
period.
Average Inventory is the average value of inventory over the same period.
Let’s consider ABC Electronics Inc. again, and assume the following financial data for
the year 2022:
• Cost of Goods Sold (COGS): I1,75,00,000
• Beginning Inventory: I40,00,000
• Ending Inventory: I30,00,000
Calculate Inventory Turnover Ratio.
​Solution:

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory

(a) Calculate Average Inventory:

63
Average Inventory = (Beginning Inventory + Ending Inventory)/2
UNIT 2
Financial Statements Analysis
NOTES Average Inventory = (I40,00,000 + I30,00,000)/2 = 35,00,000

(b) Calculate Inventory Turnover Ratio:

Inventory Turnover Ratio = I1,75,00,000/I35,00,000 = 5 times

Interpretation of example:
In this example, ABC Electronics Inc. has an Inventory Turnover Ratio of 5. This means
that, on average, the company sold and replaced its entire inventory 5 times during
the year.
Interpretation and Corporate Applicability of the Inventory Turnover Ratio:
Ideally, inventory turnover ratio should neither be too high, nor too low. An optimum
level of inventory turnover ratio reflects the balance between efficient inventory
management and meeting customer demand.
Indications of a low and a high inventory turnover ratio can be explained as:
• Low Inventory Turnover Ratio: This could be a sign of ineffective inventory
management, sluggish sales, or overstocking. Higher carrying expenses and
maybe out-of-date inventory could result from this.
• High Inventory Turnover Ratio: A high turnover ratio indicates very fast
conversion of inventory to finished good, though it indicates efficiency but
many a times it may lead to shortages of material or stock-out situation that
may lead to production halt-ups.

Calculation of Days Sales in Inventory (DSI)

There is another method of calculating the inventory level in terms of number of
days which explains as in how many days a company is able to sell its inventory.
The day in inventory is the average time a company holds its inventory before they
sell it. This is also known as inventory outstanding or inventory days of supply. It
indicates the efficiency of a firm to sell its goods and thus achieve operational and
financial performance efficiency. Days in inventory is the average time a company
keeps its inventory before it is sold.
To calculate days in inventory, divide the cost of average inventory by the cost
of goods sold, and multiply that by the period length, which is usually 365 days.
The formula is:

DSI = Average Inventory/(Cost of Goods Sold (COGS)/365

Let us understand it through a simple example.

Assume that a Dental Suppliers sells dental supplies to the dentist practicing in a
particular area. The company has an average inventory of 1,00,000 and a cost of
goods sold of Rs. 4,00,000 for the year. In this case, what will be the days in inventory
result for a one-year period?
According to the formula as stated above, the days in inventory will be:
(Rs. 1,00,000/Rs. 4,00,000) × 365. Thus. We get the days in inventory is 9.13 days.
64 This indicates that Dental Suppliers has been operating efficiently within its market
where they hold the inventory only for 9.13 days.
 FINE005
Financial Analysis and
Business Valuation
2. Accounts Receivable Turnover Ratio NOTES
The number of times an organization’s accounts receivable are collected and
replaced during a given time frame, usually a year, is measured by the accounts
receivable turnover ratio. It evaluates how well a business handles credit sales and
customer payment collection. The Ratio of Accounts Receivable Turnover Formula is
as follows:
(a) Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts
Receivable
where,
Net Credit Sales is the total amount of credit sales made during the period.
Average Accounts Receivable is the average value of accounts receivable
over the collection period
(b) Debtors Collection Period = Months/Days in a Year/Accounts Receivables
Turnover Ratio
Let’s consider ABC Electronics Inc. again, and assume the following financial
data for the year 2022:
• Net Credit Sales: I2,00,00,000
• Beginning Accounts Receivable: I30,00,000
• Ending Accounts Receivable: I20,00,000

Solution:
Calculate Average Accounts Receivable:
(a) Average Accounts Receivable = (Beginning Accounts Receivable + Ending
Accounts Receivable)/2

Average Accounts Receivable = I30,00,000 + I20,00,000/2 = I25,00,000

(b) Calculate Accounts Receivable Turnover Ratio:

Accounts Receivable Turnover Ratio = I2,00,00,000/I25,00,000 = 8 times

(c) Debtors Collection Period:

Debtors Collection Period = 12/8 = 1.5 Months
It can be calculated in days too = 365/8 = 45.62 days
Interpretation of example:
ABC Electronics Inc. in this case had eight times accounts receivable turnover ratio.
This indicates that the corporation changed and collected its accounts receivable
eight times a year on average.
Interpretation and Corporate Applicability of the Accounts Receivable Turnover Ratio:

• O
 ptimum Turnover Ratio for Accounts Receivable: The optimum ratio of
accounts receivable to turnover shows how well a business collects past-due
payments from clients. A greater ratio enhances liquidity and lowers the risk of 65
UNIT 2
Financial Statements Analysis
NOTES bad debt by indicating efficient credit management and a speedier conversion
of sales into cash. On the other hand, a smaller ratio might indicate ineffective
collection efforts or lax credit standards, which would cause cash flows to be
delayed and bad debt risk to increase.

It is essential to compare the turnover ratio to industry standards in order to assess

performance and make necessary adjustments to credit policies in order to maximise
cash flow and preserve client relationships. In the end, maintaining organisational
sustainability and profitability requires striking a balance between credit management
and sales development goals.
A meaningful evaluation of the accounts receivable turnover ratio requires comparing
it to industry norms and the company’s historical data. If the ratio is abnormally high
or low, more research should be done to determine the cause of the trend and how
it affects the company’s financial standing.
3. Accounts Payable Turnover Ratio
The accounts payable turnover ratio calculates the frequency with which a
company’s accounts payable are settled and replaced during a given time frame,
usually a year. It evaluates how well a business handles paying its creditors and
suppliers.
where,
Net Credit Purchases is the total amount of credit purchases made during the
period.
Average Accounts Payable is the average value of accounts payable over the same
period.
L​ et’s consider ABC Electronics Inc. again, and assume the following financial data for
the year 2022:
• Net Credit Purchases: I1,50,00,000
• Beginning Accounts Payable: I25,00,000
• Ending Accounts Payable: I20,00,000
Calculate Accounts Payable Turnover Ratio.
Solution:

(a) Calculate Average Accounts Payable:

Average Accounts Payable = (Beginning Accounts Payable + Ending

Accounts Payable)/2

Average Accounts Payable = (I25,00,000 + I20,00,000)/2 = I22,50,000

(b) Calculate Accounts Payable Turnover Ratio:

Accounts Payable Turnover Ratio = I1,50,00,000/22,50,000 = 6.67 times

(c) Accounts Payable Period = 365/6.67 = 54.72 = 55 days

66
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Financial Analysis and
Business Valuation
Interpretation of example: NOTES
The accounts payable turnover ratio for ABC Electronics Inc. in this case is roughly
6.67 times. This indicates that the corporation replaced and paid off its accounts
payable 6.67 times on average during the course of the year. Additionally, the
company’s turnover cycle for accounts payable is around 55 days.
Interpretation and Corporate Applicability of the Accounts Payable Turnover Ratio:
High Turnover Ratio for Accounts Payable: A high ratio, such as 6.67, indicates that
the business is paying suppliers on time and effectively. It suggests that the business
is paying its debts really rapidly, which may be an indication of robust liquidity and
positive supplier relations.
Low Accounts Payable Turnover Ratio: If this ratio is low, it may mean that the
business is undervaluing its suppliers and that this is having an adverse effect on
those relationships. It could also indicate poor payables management or financial
strain.
If the ratio is abnormally high or low, more research should be done to determine
the underlying causes and how they may affect the company’s financial standing.
4. Asset Turnover Ratio
The Asset Turnover Ratio calculates the effectiveness with which a business generates
sales revenue from all of its assets. It shows how well a business is making use of its
resources to produce revenue. The Asset Turnover Ratio is calculated as follows:

Asset Turnover Ratio = Net Sales/Average Total Assets

​where,
Net Sales is the total revenue generated from sales during the period.
Average Total Assets is the average value of total assets over the same period.
Let’s consider ABC Electronics Inc. again, and assume the following financial data for
the year 2022:
• Net Sales: I4,00,00,000
• Beginning Total Assets: I2,00,00,000
• Ending Total Assets: I2,50,00,000

Solution:

Asset Turnover Ratio = Net Sales/Average Total Assets

(a) Calculate Average Total Assets:

Average Total Assets = (Beginning Total Assets + Ending Total Assets)/2

Average Total Assets = (Rs. 2,00,00,000 + I2,50,00,000)/2 = I2,25,00,000

(b) Calculate Asset Turnover Ratio:

Asset Turnover Ratio = I4,00,00,000/I2,25,00,000 = 1.78 times 67

UNIT 2
Financial Statements Analysis
NOTES Interpretation of example:
In this example, ABC Electronics Inc. has an Asset Turnover Ratio of approximately
1.78 times. This means that, on average, the company generated I1.78 of sales for
every rupee invested in its total assets during the year.
Interpretation and Corporate Applicability of the High Asset Turnover Ratio:
• High Asset Turnover Ratio: When a ratio is high, such as 1.78, it means
that the business is making good use of its assets to produce sales income.
It implies that the business is making efficient use of its resources to increase
sales, possibly by implementing successful production, distribution, and
marketing plans.
• Low Asset Turnover Ratio: If this ratio is low, it may indicate that the company
is not making the best use of its assets to produce income. This might be the
result of things like unused capacity, ineffective business practices, or a drop in
customer interest in the company’s goods or services.
5. Operating Cycle
The period of time it takes for a business to transform its raw materials into finished
goods, sell those things, and then collect money from clients is referred to as the
operating cycle, also known as the cash conversion cycle. It calculates how long it
takes a business to turn resources into cash by cycling through its production and
sales processes. Calculating the Operating Cycle yields:

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding

where,
• Days Inventory Outstanding (DIO) is a measure of how long it typically takes a
business to sell its inventory.
• Days Sales Outstanding (DSO) is a measure of how long it typically takes a
business to get paid by its clients.
Let’s consider ABC Electronics Inc. again and assume the following data for the year
2022:

• Days Inventory Outstanding (DIO): 60 days

• Days Sales Outstanding (DSO): 45 days
Solution:

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding

(a) Calculate Operating Cycle:

Operating Cycle = 60 days + 45 days = 105 days

Interpretation of example:
The operating cycle of ABC Electronics Inc. in this case is 105 days. This indicates that
the entire cycle, from acquiring raw materials to receiving payment from clients,
takes the business, on average, 105 days to complete.
68
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Financial Analysis and
Business Valuation
Interpretation and Corporate Applicability of the Operating Cycle: NOTES
• A Short Operating Cycle: A shorter operating cycle shows that the business is
running its sales, production, and collection operations profitably. It suggests
that the business can turn its resources into cash fast, which could improve
cash flow and liquidity.
• An Extended Operating Cycle: Extended operating cycles may indicate
inefficiencies in the way the business cycle’s various stages are managed. It can
be the result of protracted production schedules, sluggish inventory turnover,
or delayed sales collections.

2.8 VALUATION RATIOS

Valuation ratios, also known as price ratios or market ratios, are financial indicators that
are used to assess the relative value of a company’s shares or assets based on cash flows,
book value, profitability, and other financial factors. These figures provide insight into
how the market evaluates a company’s performance and prospects for future growth.
Valuation metrics are widely used by analysts, investors, and other financial experts to
evaluate a company’s stock attractiveness and assist in investment decision-making.
1. Price-to-Earnings (P/E) Ratio
A valuation ratio called Price-to-Earnings (P/E) compares the current stock price of
a firm to its earnings per share (EPS). It shows how much investors are prepared to
pay for each unit of earnings and reflects the market’s assessment of a company’s
earnings potential. P/E ratio formula is as follows:

P/E Ratio = Stock Price/Earnings Per Share

​where:
Stock Price is the current price of one share of the company’s stock.
Earnings Per Share (EPS) is the company’s net income divided by the number of
outstanding shares.
Let’s consider ABC Electronics Inc. again and assume the following financial data for
the year 2022:

• Stock Price: I300 per share

• Earnings Per Share (EPS): I15

Calculate EPS.
Solution:

P/E Ratio = Stock Price/Earnings Per Share

Calculate P/E Ratio:

P/E Ratio = I300/I15 = 20 times

69
UNIT 2
Financial Statements Analysis
NOTES Interpretation of example:
The Price-to-Earnings (P/E) ratio of ABC Electronics Inc. in this instance is 20.
This indicates that in order to purchase stock in the company, investors are prepared
to pay 20 times its current earnings per share.
Interpretation and Corporate Applicability of P/E Ratio:
• High P/E Ratio: A high ratio, like 20, suggests that investors expect the company’s
profits to expand faster in the future. It could indicate that the public believes
the company has a lot of space to grow or is more profitable than its rivals.
• Low P/E Ratio: A low P/E ratio could indicate that investors are less confident
in the company’s ability to grow profits in the future. It may suggest that the
company’s earnings are currently less predictable or lower in comparison to
the stock price.
By contrasting the P/E ratio with industry averages, the company’s historical P/E
ratio, and the P/E ratios of similar companies, a more insightful understanding can
be reached. The P/E ratio of a company may not always be a reliable indicator of its
value, and vice versa. A low P/E ratio is not always a sign of an inexpensive stock. Other
factors, including as market conditions, growth potential, and risk concerns, should
be considered when evaluating the P/E ratio and making investment decisions.
2. Price-to-Book (P/B) Ratio
Price-to-Book (P/B) is a valuation ratio that assesses a company’s current stock price
in relation to its book value per share. It illustrates how an organization’s assets are
valued by the market in relation to their book value. The following formula can be
used to determine the P/B ratio:

P/B Ratio = Stock Price/Book Value Per Share

Where:
Stock Price is the current price of one share of the company’s stock.
Book Value Per Share is the company’s total equity (assets minus liabilities) divided
by the number of outstanding shares.
Let’s consider ABC Electronics Inc. again and assume the following financial data for
the year 2022:
• Stock Price: I400 per share
• Book Value Per Share: I300

Solution:
P/B Ratio = Stock Price/Book Value Per Share

Calculate P/B Ratio:

P/B Ratio = I400/I300 = 1.33 times

Interpretation of example:
The Price-to-Book (P/B) ratio for ABC Electronics Inc. in this case is roughly 1.33.
70 This indicates that in order to purchase a share of the company’s stock, investors are
prepared to pay 1.33 times the book value per share.
 FINE005
Financial Analysis and
Business Valuation
Interpretation and Corporate Applicability of P/B Ratio: NOTES
• High P/B Ratio: A high ratio, like 1.33, suggests that investors think the company’s
assets are worth more than their book value. It could indicate that investors are
looking beyond book value to the company’s potential for future growth.
• Low Price-to-Book Ratio: If the P/B ratio is low, it could indicate that investors
are pricing the company’s assets below their book value. It could indicate that
the company’s financial stability is questioned or that there isn’t much space
for growth in its assets.
Meaningful interpretation requires comparing the P/B ratio to industry peers, the
company’s previous P/B ratios, and the company’s growth expectations. P/B ratios,
whether high or low, should be examined in conjunction with other elements that
impact investor mood and the company’s valuation.
3. Price-to-Sales (P/S) Ratio
A valuation ratio called Price-to-Sales (P/S) compares the current stock price of a
firm to its revenue per share. It shows how much the market is prepared to pay for
each unit of sales and displays how much a company’s sales success is valued by
investors. P/S ratio formula is as follows:

P/S Ratio = Stock Price/Revenue Per Share

​where:
Stock Price is the current price of one share of the company’s stock.
Revenue Per Share is the company’s total revenue divided by the number of
outstanding shares.
Let’s consider ABC Electronics Inc. again and assume the following financial data for
the year 2022:
• Stock Price: I250 per share
• Revenue Per Share: I50

Solution:

P/S Ratio = Stock Price/Revenue Per Share

Calculate P/S Ratio:

P/S Ratio = I250/I50 = 5 times

I​ nterpretation of example:
In this example, ABC Electronics Inc. has a Price-to-Sales (P/S) ratio of 5. This means
that investors are willing to pay 5 times the company’s revenue per share to own a
share of its stock.
Interpretation and Corporate Applicability of P/S Ratio:
• High P/S Ratio: When a P/S ratio is high, such as 5, it indicates that investors
are placing a higher value on the company’s sales performance. It can be a sign
that investors are optimistic about the company’s ability to generate revenue
71
and grow.
UNIT 2
Financial Statements Analysis
NOTES • Low P/S Ratio: If the P/S ratio is low, it may be a sign that investors are
undervaluing the sales performance of the company. It can mean that investors
are less optimistic about the company’s ability to grow or that they have doubts
about its capacity to bring in sizable sums of money.
4. Enterprise Value-to-EBITDA (EV/EBITDA) Ratio
A valuation ratio called Enterprise Value-to-EBITDA (EV/EBITDA) compares a company’s
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) to its enterprise
value, which is the market value of stock plus debt less cash. It offers a more thorough
understanding of the valuation of a business by taking into account both its capital
structure and operating performance. The ratio’s formula, which is EV/EBITDA, is:

EV/EBITDA Ratio = Enterprise Value/EBITDA

where:
The entirety of the company’s market capitalization, total debt, and minority interest
less cash and cash equivalents is its enterprise value, or EV. The part of a subsidiary’s
earnings that goes to minority shareholders rather than the main firm is referred to
as a minority interest. Minority interest is added back to EBITDA (earnings before
interest, taxes, depreciation, and amortization) when figuring up the EV/EBITDA ratio
since EBITDA shows the whole earnings produced by the company, including the
amount attributable to minority owners. The ratio offers a more complete picture
of the business’s operating success by recalculating minority interest to EBITDA,
especially when the business has sizable minority interests in subsidiaries.
A minority interest is referred to a stake in a company where more than 50 per cent
stake in the equity is held by the parent company and in such a case, the subsidiary
company holds less than 50 per cent stake and voting rights.
The company’s operating success is measured by Earnings Before Interest, Taxes,
Depreciation, and Amortization, or EBITDA.
Let’s consider ABC Electronics Inc. again and assume the following financial data for
the year 2022:
• Market Capitalization: I1,000,00,000
• Total Debt: I300,00,000
• Cash and Cash Equivalents: I50,00,000
• EBITDA: I2,50,00,000

Solution:

EV/EBITDA Ratio = Enterprise Value/EBITDA

(a) Calculate Enterprise Value (EV):

EV = Market Capitalization + Total Debt − Cash and Cash Equivalents

EV = I1,000,00,000 + I300,00,000 − I50,00,000 = I1,250,00,000
72 (b) Calculate EV/EBITDA Ratio:
 FINE005
Financial Analysis and
Business Valuation
EV/EBITDA Ratio = I1,250,00,000/I2,50,00,000 = 5 times NOTES

Interpretation of example:
In this example, ABC Electronics Inc. has an Enterprise Value-to-EBITDA (EV/EBITDA)
ratio of 5. This means that the company’s enterprise value is 5 times its EBITDA.
Interpretation and Corporate Applicability of EV/EBITDA Ratio:
• High EV/EBITDA Ratio: An enterprise value of the business that is higher than
its EBITDA is indicated by a high ratio, such as 5. This can suggest that the
company is valued more highly than its actual performance. It could be an
indication of overvaluation or excessive expectations for future growth.
• Low EV/EBITDA Ratio: The presence of a low EV/EBITDA ratio may indicate that
the company’s valuation is comparatively lower than its EBITDA. It can be a sign
of conservative investor sentiment or undervaluation.
An overvalued company does not always indicate a lower ratio of EV/EBITDA, while an
undervalued stock does not always indicate a higher ratio. To make wise investment
selections, more research into market circumstances, company fundamentals, and
industry trends is required.
5. Dividend Yield
A financial indicator called dividend yield shows the annual dividend income as a
percentage of the stock price. Based on the dividends paid, it shows the expected
return on investment that a shareholder in a corporation might anticipate receiving.
The Dividend Yield formula is as follows:

Dividend Yield = (Annual Dividend Per Share/Stock Price) × 100%

where:
The total yearly dividends paid by the business divided by the total number of
outstanding shares is known as the annual dividend per share.
The current value of one share of the company’s stock is known as the stock price.
Let’s consider ABC Electronics Inc. again and assume the following financial data for
the year 2022:
• Annual Dividend Per Share: I10
• Stock Price: I200 per share

Solution:

Dividend Yield = (Annual Dividend Per Share/Stock Price) × 100%

Calculate Dividend Yield:

Dividend Yield = I10/I200 × 100% = 5%

Interpretation of example:
In this example, ABC Electronics Inc. has a Dividend Yield of 5%. This means that
an investor purchasing the stock at I200 per share can expect an annual dividend 73
income of 5% of their investment.
UNIT 2
Financial Statements Analysis
NOTES Interpreting the Dividend Yield:

• High Dividend Yield: If a company has a high dividend yield (e.g., 5%), it means
that a sizable portion of its earnings are being distributed as dividends. Investors
that are looking for consistent dividend income and are income-oriented may
find it appealing.
• Low Dividend Yield: If a company has a low dividend yield, it may be holding
onto more of its earnings for expansion and growth rather than paying out
dividends.
A meaningful interpretation depends on comparing the Dividend Yield to industry
rivals, the company’s past dividend yields, and its growth prospects. Income-focused
investors may find a greater dividend yield enticing, but when assessing dividend
yield as an investment criterion, it’s crucial to take the company’s overall financial
health, dividend policy, and other factors into account.

2.9 DuPONT ANALYSIS

The DuPont analysis was developed in the 20th century, by Donaldson Brown, who worked
as a treasurer in DuPont Corporation.
The primary goal of the analysis was to assess the company’s return on equity (ROE) and
all of its constituent parts in order to comprehend and enhance its financial performance.
DuPont analysis is very helpful in determining the advantages and disadvantages of a
business’s financial structure and operations. It aids in addressing important queries: Are
sales bringing in a solid profit for the company? Is it effectively allocating its resources to
optimize earnings? Is it using the right amount of debt to increase profits? DuPont analysis
helps decision-makers by answering these queries, enabling them to improve strategies
and maximize the ROE for the company’s shareholders.
Initially, the research was utilized internally by the DuPont Corporation to evaluate its
financial situation, pinpoint possibilities for development, and make well-informed strategic
choices. The DuPont analysis became well-known throughout time for its ability to dissect
ROE into important elements including profit margin, asset turnover, and equity multiplier.
Furthermore, DuPont analysis is a crucial tool for analysts and investors evaluating possible
investments thus expanding the scope for its operations. By using this framework, they
can obtain a more thorough understanding of a business’s financial situation than only
looking at its ROE. This knowledge can be particularly helpful when comparing businesses
in the same industry or different industries.
Three primary components comprise ROE according to the DuPont analysis:
1. PM (Profit Margin): This part assesses how profitable the business can make its
sales revenue. It determines how much of every rupee of revenue is converted
into net income. The profit margin calculation is:
Profit Margin = Net Income/Revenue
2. ​ sset Turnover (AT): This component measures how efficiently a company utilizes
A
its assets to generate sales revenue. It calculates the ratio of revenue to average
total assets. The formula for asset turnover is:
74
Asset Turnover = Revenue/Average Total Assets
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Financial Analysis and
Business Valuation
3. E​ quity Multiplier (EM): This component reflects the extent to which a company NOTES
relies on debt financing to boost returns. It calculates the ratio of average total
assets to average shareholders’ equity. The formula for equity multiplier is:

Equity Multiplier = Average Total Assets/Average Shareholders’ Equity

The DuPont analysis combines these components using the following relationship:

ROE = Profit Margin × Asset Turnover × Equity Multiplier

The advantage of the DuPont study is that it enables analysts and investors to break out a
company’s ROE drivers and comprehend how adjustments to various constituents affect
overall profitability. DuPont analysis, for instance, can assist in identifying if a company’s
rising return on equity (ROE) is attributable to improved asset utilization, larger profit
margins, or more financial leverage.
Businesses and investors can use the DuPont analysis to make better decisions that will
improve overall financial performance by gaining a deeper understanding of the sources
of profitability and pinpointing areas for improvement.

2.9.1 USES OF DuPONT ANALYSIS

DuPont analysis is used for several key reasons in financial analysis and decision-making:
1. A More Comprehensive Understanding of ROE: Profit margin, asset turnover,
and equity multiplier are the three main components of return on equity (ROE)
that are separated out by DuPont analysis. This analysis offers a thorough grasp
of the factors influencing a business’s total profitability.
2. Determining Strengths and Weaknesses: DuPont research uses ROE to pinpoint
the precise areas in which a business succeeds or struggles. For example, if a
company’s return on equity (ROE) is poor, the study might indicate whether low
profit margins, inefficient asset use, or an excessive dependence on debt are the
cause of the problem.
3. Benchmarking: Through DuPont research, businesses may assess how they
stack up financially against rivals in the same industry. This makes it easier to
determine whether the company’s profitability is keeping up with or falling short
of industry norms.
4. Strategy Formulation: Businesses can create strategies to enhance particular
elements by comprehending the fundamental elements influencing profitability.
For instance, if profit margins are slim, the business may concentrate on price or
cost-cutting measures.
5. Making Investment Decisions: Investors assess a company’s performance and
financial health using DuPont analysis. Investors can choose whether to purchase
a company’s shares with more knowledge if they are aware of the factors that
influence return on equity (ROE).
6. Performance Monitoring: Over time, businesses can use DuPont analysis to
track changes in their financial performance. The study aids in identifying the
elements that are contributing to an improvement in ROE. 75
UNIT 2
Financial Statements Analysis
NOTES 7. Risk Assessment: Financial risk areas can be identified using DuPont analysis.
A large equity multiplier, for example, can suggest a heavy reliance on debt,
which could be dangerous during a recession.
8. Stakeholder Communication: DuPont analysis is a helpful tool for informing
shareholders, management, and board members about financial performance
and strategies.
To put it simply, DuPont analysis offers an organized method for dissecting and comprehending
the intricate relationships that influence a business’s financial performance. Through the
identification of the underlying factors influencing fluctuations in profitability, investors
and businesses can better manage resources, make more informed decisions, and pursue
sustainable growth.
To understand it how it works let us solve the below illustration:
Let’s consider XYZ Corporation, a manufacturing company. We’ll use the following financial
data for the year 2022:
• Net Income: I5,00,00,000
• Revenue: I20,00,00,000
• Average Total Assets: I15,00,00,000
• Average Shareholders’ Equity: I10,00,00,000
• Total Debt: I4,00,00,000

Solution:
Step 1: Calculate Components of DuPont Analysis
(a) Profit Margin (PM) = Net Income/Revenue
• Net Income = I5,00,00,000
• Revenue = I20,00,00,000
Profit Margin (PM) = 5,00,00,000/20,00,00,000 = 0.25
(b) Asset Turnover (AT) = Revenue/Average Total Assets:
• Revenue = I20,00,00,000
• Average Total Assets: I15,00,00,000
Asset Turnover = 20,00,00,000/15,00,00,000 = 1.33
(c) Equity Multiplier (EM) = Average Total Assets/Average Shareholders’ Equity
• Average Total Assets: I15,00,00,000
• Average Shareholders’ Equity: I10,00,00,000
Equity Multiplier = 15,00,00,000/10,00,00,000 = 1.5
Step 2: Calculate Return on Equity (ROE)

ROE = Profit Margin × Asset Turnover × Equity Multiplier

ROE = PM × AT × EM = 0.25 × 1.33 × 1.5 = 0.50

76
0.5 × 100 = 50%
 FINE005
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Business Valuation
Interpretation of example: NOTES
In this example, we’ve performed a DuPont Analysis for XYZ Corporation, and the resulting
ROE is 0.50 or 50%.
Interpreting the Results:
• Profit Margin (PM): A profit margin of 0.25 (25%) means that, after deducting
expenses, the business keeps 25% of net income for each rupee of revenue
generated. This shows how effectively the business turns sales into profits.
• Asset Turnover (AT): With an average total asset value of 1.33 rupees, the company
makes I1.33 in revenue for each rupee of assets. Increased asset turnover is a
symptom of efficient sales generation and successful asset usage.
• Equity Multiplier (EM): An organization using 1.5 times as many assets financed by
equity as by debt is indicated by an equity multiplier of 1.5. This implies a moderate
level of debt.
• Return on Equity (ROE): The final ROE of 0.50 (50%) represents the total return on
equity invested by shareholders. It combines financial leverage, asset efficiency,
and profitability of the business.
Remember that while DuPont Analysis offers an in-depth look at a business’s financial
performance, for a thorough evaluation of the company’s financial standing and future
prospects, it should be interpreted in conjunction with other pertinent financial metrics,
industry benchmarks, and qualitative factors.

2.10 LET US SUM UP

Ratio analysis helps to assess the financial condition of a firm.
With the help of ratio analysis, firms can make well-informed strategic and investment
decisions, and can make comparisons between businesses in the same sector or within it.
Ratio analysis includes various types of ratios classified into key categories:
• Liquidity Ratios: Evaluate a business’s capacity to fulfil immediate obligations.
• Solvency ratios are a useful tool for evaluating a company’s long-term financial
health and capacity to fulfil commitments.
• Earning capacity Ratios: Assess the profitability of a business in relation to sales,
assets, and equity.
• Efficiency Ratios: Show how well a business handles its assets, obligations, and
resources.
• Valuation Ratios: By contrasting the stock price with financial indicators such as
earnings, book value, or sales, firms can gauge the mood of the market.

Interpreting ratios involves comparing a company’s current ratios to previous ratios to

identify trends, facilitate benchmarking and assess performance.
While ratio analysis offers valuable insights and has many advantages, it also has certain
limitations and drawbacks. External economic, governmental, or sector-specific factors
may have an impact on ratios.
Different businesses and sectors may have different ratios.
77
Ratio analysis concentrates on numerical figures, thus ignoring other qualitative factors
that can influence the performance of a company.
UNIT 2
Financial Statements Analysis
NOTES The best results from ratio analysis come from combining it with other techniques
for financial research like DuPont analysis, trend analysis, and common-size financial
statements. Combining several techniques allows for a more thorough knowledge of the
financial health of a business.
Profit margin, asset turnover, and equity multiplier are the three components of ROE
that are broken down by DuPont analysis. This helps identify a company’s strengths and
shortcomings and offers insights into the elements influencing its profitability.

2.11 KEYWORDS
Assets: The resources that a corporation owns and has economic value are called assets.
These can be either intangible (such as patents and trademarks) or tangible (such as cash,
property, and machinery).
Liquidity: The ability of a company to convert assets to cash.
Solvency: The ability of a company to meet its long-term debts.
Current Assets: Those assets that can be readily converted into cash within an accounting
period, usually one year. These include cash in hand and at bank, bills receivables, short-
term investments, debtors etc.
Current Liabilities: Those liabilities that need to be paid within an accounting period,
usually one year. These include bills payables, creditors etc.
Deferred Expense: A prepaid expense that a company has paid for in advance of actually
receiving the benefit of the goods or services. It is considered as an asset.
Gross Profit: Gross profit is the financial gain of a company after deduction of the costs
necessary to manufacture and distribute its goods or services.
Operating Profit: It is the net income of a firm from its core operations after accounting
for operating expenses.
Net Profit: It is the total earning of a firm after deducting all expenses.
Cost of Goods Sold (COGS): The direct costs associated with producing goods or services,
including materials, labor, and overhead.
Earnings Per Share (EPS): It is the company’s net income divided by the number of
outstanding shares.
DuPont Analysis: It is one of the key financial metrics that breaks down and understands
the financial profitability of a company.

CHECK YOUR PROGRESS – III

Table 2.2: Financial Statement

Description 2022 2021 2020

Amount Amount Amount
in ‘000 in ‘000 in ‘000
Income Statement D D D
78 Revenue 5,000 4,000 3,780
(Continues)
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Table 2.2: Financial Statement (Continued)
NOTES
Description 2022 2021 2020
Amount Amount Amount
in ‘000 in ‘000 in ‘000
Cost of Goods Sold 2,670 2,130 1,890
Interest Expense 43 380 320
Tax Expense 25 200 150
Income from Cont Operations 2,330 1,870 1,890
Net Income 2,262 1,290 –
Balance Sheet –
Cash 2,070 1,359 1,123
Short Term Investments 722 315 265
Accounts Receivable 2,340 2,134 1,679
Inventory 2,500 1,222 985
Current Assets 7,632 5,030 4,052
Long Term Investments 1,000 435 –
Net Fixed Assets 8,632 5,465 –
Other Assets 0 0 –
Total Assets 8,632 5,465 4,300
Current Liabilities 2,221 1,543 1,367
Total Liabilities 2,411 2,285 1,863
Total Stockholders’ Equity 4,000 3,500 1,070
Cash Flow –
Cash Flow from Operations 3,150 2,814 2,345
Dividends Paid 120 87 112
Interest Paid 43 31 44
Share Information –
Market Price at Year End 110.00 96.00 78.00
Earnings Per Share–Basic 3.50 3.50 2.15
Shares Outstanding 0 0 0

Calculate and interpret the ratios for 2022 and 2021:

1. Receivable Turnover Ratio
2. Inventory Turnover Ratio
3. Current Ratio
4. Quick Ratio
5. ROA
6. P/E Ratio
7. Net Profit Ratio 79
UNIT 2
Financial Statements Analysis
NOTES 2.11.1 SELF LEARNING
(a) From the Check your progress III information can you calculate any other ratios
that you have learnt in this Chapter?
(b) The Balance Sheet and Profit and Loss Statement of Asian Paints Limited for
March 2022 and March 2023 is given below:
You have to go through items available in the financial statements to
1. Identify relevant ratios that can be calculated from the given information
2. Write the relevant formula
3. Calculate the ratios
4. Interpret the ratios
Hint: For instance, if we look at Balance Sheet, we can identify Current Assets and Current
Liabilities, we can calculate Current Ratio, similarly find the other ratios.

2.11.2 PROFIT & LOSS ACCOUNT AND BALANCE SHEET

OF ASIAN PAINTS

Table 2.3: 2023 Profit & Loss Account of Asian Paints

Asian Paints Ltd.

Income Details: Mar 2014 – Mar 2023: Non- Mar-22 Mar-23
Annualised: Rs. Million 12 mths 12 mths
INDAS INDAS

Total income 301,610.30 363,114.30

Sales 296,617.20 358,249.40
Industrial sales 295,221.30 356,648.90
Sale of goods 294,551.20 355,981.10
Sale of scrap 320.1 247.4
Sale of raw materials and stores
Job-work income 350 385.1
Income from repairs & maintenance
Construction income
Sale of electricity, gas and water
Fiscal benefits
Other industrial sales 35.3
Income from non-financial services 1,395.90 1,600.50
Trading income
Rent income
Income from financial services 2,185.80 2,837.90
80
(Continues)
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Table 2.3: 2023 Profit & Loss Account of Asian Paints (Continued)
NOTES
Asian Paints Ltd.
Income Details: Mar 2014 – Mar 2023: Non- Mar-22 Mar-23
Annualised: Rs. Million 12 mths 12 mths
INDAS INDAS

Fee based financial services income

Fund based financial services income 2,185.80 2,837.90
Interest income 719.2 946.9
Dividends 273.5 704.8
Bill discounting
Leasing & hire purchase income
Lease equalisation adjustment
Share of profit in partnership firms, subs, jv
& other costs
Profit on securitisation of assets & loans
Income from treasury operations 1,193.10 1,186.20
Gain on securities transactions, sale of invest 760.9 1,186.20
Profit on long term securities transactions
Profit on current securities transactions
Profit on revaluation of investments 760.9 1,186.20
Gain relating to forex transactions 432.2
Adjustments to the carrying amount of investments-
reversals
Other income 2,335.20 1,600.40
Prior period and extraordinary income 472.1 426.6
Prior period income 10.8 275.8
Cash prior period income
Bad debts recovered
Cash prior period income, others
Non-cash prior period income 10.8 275.8
Provisions written back 10.8 275.8
Non-cash prior period income, others
Extraordinary income 461.3 150.8
Profit on sale of fixed assets 403.6 114.5
Profit on sale of investment in subsidiary
Insurance claims 22.4 4.9
Gain on change in accounting policies 81
(Continues)
UNIT 2
Financial Statements Analysis
Table 2.3: 2023 Profit & Loss Account of Asian Paints (Continued)
NOTES
Asian Paints Ltd.
Income Details: Mar 2014 – Mar 2023: Non- Mar-22 Mar-23
Annualised: Rs. Million 12 mths 12 mths
INDAS INDAS

Income from discontinued operations

Gain on disp of ast/settlement of discount oper liab
Less: Income capitalised
Less: Income transferred to DRE
Change in stock 12,086.30 2,997.40
Change in stock of finished goods 11,517.80 3,099.10
Change in stock of wip and semifinished goods 568.5 –101.7
Change in stock of real estate and construction

2.11.3 BALANCE SHEET

Table 2.4: 2023 Balance Sheet of Asian Paints

Asian Paints Ltd.

Total Liabilities: Mar 2014 – Mar 2023: Non-Annualised: Mar-22 Mar-23
Rs. Million 12 mths 12 mths
INDAS INDAS
Shareholder’s funds 131,990.60 153,607.10
Total capital 959.2 959.2
Reserves and funds 132,531.70 154,896.40
Share appln money & suspense account
Borrowings 7,141.80 8,923.00
Borrowing from banks
Borrowing from financial institutions
Borrowings from central & state govt
Borrowings syndicated across banks & institutions
Debentures and bonds
Foreign currency borrowings
Loans from promoters, directors & shareholders
Inter-corporate loans
Deferred credit 161.6 493.6
Interest accrued and due
82
(Continues)
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Table 2.4: 2023 Balance Sheet of Asian Paints (Continued)
NOTES
Asian Paints Ltd.
Total Liabilities: Mar 2014 – Mar 2023: Non-Annualised: Mar-22 Mar-23
Rs. Million 12 mths 12 mths
INDAS INDAS
Hire purchase loans 6,980.20 8,429.40
Fixed deposits
Sub-ordinated debt (bank)
Borrowings from rbi
Commercial papers
Other borrowings
Deferred tax liability 2,942.60 2,682.20
Current liab incl long term portion & excl borr 53,316.20 55,265.10
Sundry creditors 41,328.20 38,492.70
Sundry creditors for goods and services 40,961.80 37,292.50
Sundry creditors for capital works 366.4 1,200.20
Of which: sundry creditors from gp & subs cos
Acceptances
Deposits & advances from customers and employees 734.2 1,232.70
Security, trade and dealer deposits 235.5 451.6
Advances from customers on cap account
Advances from customers on rev account 498.7 781.1
Deposits from employees
Interest accrued but not due
Share application money—refundable
Other current liabilities 11,253.80 15,539.70
Provisions 4,096.10 4,827.70
Corporate tax provision 1,008.50 1,128.90
Other direct & indirect tax provisions 129.3 112.8
Provision for bad and doubtful debts 1,014.70 1,351.40
Total dividend provisions
Dividend tax provision
Provision for employee benefits 1,934.40 2,111.80
Other provisions 9.2 122.8
Total Liabilities 200,987.60 227,553.60 83
UNIT 2
Financial Statements Analysis
Table 2.5: 2023 Key Financial Ratios of Asian Paints for the year 2022 & 2023
NOTES
Key Financial Ratios of Asian Paints (in Rs. Cr.) MAR 23 MAR 22
Per Share Ratios
Basic EPS (Rs.) 42.76 32.68
Diluted EPS (Rs.) 42.76 32.68
Cash EPS (Rs.) 50.63 40.20
Book Value [ExclRevalReserve]/Share (Rs.) 162.48 139.17
Book Value [InclRevalReserve]/Share (Rs.) 162.48 139.17
Dividend/Share(Rs.) 25.65 19.15
Revenue from Operations/Share (Rs.) 313.58 262.60
PBDIT/Share (Rs.) 66.08 52.54
PBIT/Share (Rs.) 58.20 45.02
PBT/Share (Rs.) 57.23 43.73
Net Profit/Share (Rs.) 42.75 32.68
Profitability Ratios
PBDIT Margin (%) 21.07 20.00
PBIT Margin (%) 18.56 17.14
PBT Margin (%) 18.25 16.65
Net Profit Margin (%) 13.63 12.44
Return on Networth/Equity (%) 26.30 23.48
Return on Capital Employed (%) 33.43 30.27
Return on Assets (%) 18.19 15.74
Total Debt/Equity (X) 0.00 0.00
Asset Turnover Ratio (%) 1.42 1.34
Liquidity Ratios
Current Ratio (X) 2.38 2.26
Quick Ratio (X) 1.47 1.32
Inventory Turnover Ratio (X) 2.79 3.29
Dividend Payout Ratio (NP) (%) 46.55 55.53
Dividend Payout Ratio (CP) (%) 39.30 45.14
Earnings Retention Ratio (%) 53.45 44.47
Cash Earnings Retention Ratio (%) 60.70 54.86
Source: https://www.cmie.com/

2.12 REFERENCES AND SUGGESTED ADDITIONAL READINGS

REFERENCES
84 1. Narayanaswamy R. Financial Accounting: A Managerial Perspective. PHI Learning
Pvt. Ltd., Delhi.
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2. Robert N. Anthony, David F. Hawkins, Kenneth A. Merchant. Accountancy- text and NOTES
cases. McGraw Hill Education (India) Private Limited, New Delhi.
3. Maheshwari S. N., Maheshwari Sunil K., and Maheshwari Sharad K, An Introduction
to Accountancy, Vikas Publishing

SUGGESTED WEB READING

1. https://static.careers360.mobi/media/uploads/froala_editor/files/Financial-
Analysis-and-Planning-Ratio-Analysis.pdf
2. https://www.scranton.edu/faculty/hussainold/teaching/fin361_/Fin361C03.pdf

2.13 SELF-ASSESSMENT QUESTIONS

1. If debt equity ratio is 2:1. The funds from long term sources are Rs. 12 lac. In this
case, the amount of tangible net worth will be;
(a) Rs. 12 lac.
(b) Rs. 8 lac
(c) Rs. 4 lac.
(d) Rs. 2 lac.
2. Suppose Debt Equity Ratio is 3:1. Total assets Rs. 20 lac and current ratio is 1.5:1
The owned funds are Rs. 3 lac. The current asset will be;
(a) Rs. 5 lac
(b) Rs. 3 lac
(c) Rs. 12 lac
(d) none of the above.
3. A well accepted Debt Equity Ratio is;
(a) 1:1
(b) 1:3
(c) 2:1
(d) 3:1
4. What will be the effect of revaluation of assets on company’s net worth?
(a) The net worth will improve
(b) Will remain same
(c) Will be positive
(d) No Effect
5. In a business entity, an asset contributes to;
(a) Source of fund
(b) Use of funds
(c) Inflow of funds 85
(d) All the above
UNIT 2
Financial Statements Analysis
NOTES 6. Assume total assets shown in the balance sheet are Rs. 10 lac, current liabilities
Rs. 5 lac
And capital & reserves are Rs. 2 lac, the debt-equity ratio will be;
(a) 1;1
(b) 1.5:1
(c) 2:1
(d) None of them
7. The current ratio in the previous year was 3:1, while quick ratio at 2:1. In the current
year, the current ratio is 3:1. However, quick ratio changed to 1:1. This indicates that
the firm is;
(a) highly liquid
(b) having higher stock
(c) has lower stock
(d) has low liquidity
8. Which is the following method is used to measure the degree of solvency between
two firms;
(a) Net worth
(b) Tangible Net Worth
(c) Asset coverage ratio
(d) Solvency Ratio
9. If current ratio of a firm is 1, the net working capital will be;
(a) Positive
(b) Negative
(c) Zero
(d) None of the above
10. A company has current ratio of 4:1. Assume that net working capital is Rs. 30,000.
In this case, what will be the current assets of the company?
(a) Rs. 10,000
(b) Rs. 40,000
(c) Rs. 24,000
(d) Rs. 6,000

2.14 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check your progress – I
(a) True
86 (b) True
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(c) False NOTES
(d) False
(e) False
Check your progress – II
(a) False
(b) False
(c) False
(d) True
(e) False
(f) True
Check Your Progress – III
Answers
Receivable Turnover Ratio 2.2 2.1
Inventory Turnover Ratio 1.4 1.9
Current Ratio 3.44 3.26
Quick Ratio 2.31 2.47
ROA 33.1% 38.3%
P/E ratio 31.4 27.4
Net Profit Ratio 44.6% 48.6%

2.15 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (b) 2. (c) 3. (c) 4. (a) 5. (b)
6. (d) 7. (b) 8. (d) 9. (c) 10. (b)

87
 UNIT 3
CASH FLOW STATEMENT

STRUCTURE
3.0 Objectives
3.1 Introduction
3.2 Meaning, Sources and Uses of Cash and its Usefulness
3.3 What is a Cash Flow Statement
3.4 Components of Cash Flow Statement
3.5 Methods for Preparing Cash Flow Statements
3.6 Analysis of Cash Flow Statement
3.7 Cash Flow Analysis
3.8 Significance of Cash Flow Analysis
3.9 Case Study on Cash Flow Analysis
3.10 Let Us Sum Up
3.11 Keywords
3.12 References and Suggested Additional Reading
3.13 Self-Assessment Questions
3.14 Check Your Progress – Possible Answers
3.15 Answers to Self-Assessment Questions

3.0 OBJECTIVES
After reading this unit, you will be able to:
1. understand the meaning and objectives of the cash flow statement.
2. comprehend the purpose and significance of a cash flow statement.
3. identify the various components of a cash flow statement.
4. apply the concept to analyze cash flow statements.
5. discuss the advantages and disadvantages of cash flow statements.

89
UNIT 3
Cash Flow Statement
NOTES RECAP FROM UNIT 2
In the previous chapter, we have discussed in detail about the meaning of ratio
analysis. We have comprehended a range of ratios, including liquidity ratios, solvency
ratios, profitability ratios, efficiency ratios, and valuation ratios.
We have understood that ratio analysis is a valuable tool utilized to assess an organization’s
financial information in order to gain a thorough knowledge of its actual position.
The utilisation of this tool enables the assessment of various aspects of a company’s
performance, including its financial performance, operational efficiency, profitability,
liquidity, solvency, risk levels, and effective utilisation of funds. Furthermore, this tool can
assist financial professionals in comprehending patterns within companies and conducting
competitive analysis.

3.1 INTRODUCTION
In this Unit, we will discuss the cash flow statement. We have learned so far that financial
statements consist of Position Statement (which illustrates how much assets and liabilities
a company has at a certain point in time) and the Income Statement (which illustrates
how much profit the organization made). A third important financial statement is the cash
flow statement, which shows how much cash and cash equivalents flows in and out of the
business. Cash flow statement acts as a financial compass which gives full information on
financial health & operational efficiency of the company. It shows the inflows and outflows
of cash indicating how the business generates and uses money during a particular period
of time. This essential financial statement comprises three vital components: they involve
operating activities, investing activities, and financing.
The analysis of a cash flow statement can be equated to a deep exploration of a
company’s financial essence, as it uncovers the complexities of cash flow dynamics,
thereby providing a holistic depiction of its financial well-being and operational
effectiveness. The process entails examining the financial statements of a company in
order to gain insights into its solvency, liquidity, and resilience in the face of economic
fluctuations. It provides investors, financial analysts, and business leaders with a wealth
of valuable information.
Therefore, cash flow statement analysis does not only involve mere numerical
calculations, rather, it’s highly sophisticated examination, revealing crucial information.
Cash generated from operating activities shows how a firm can survive its own business
operation without new loans or sale of assets. From this perspective, investing activities
illustrate a company’s strategic intent towards acquiring or disposing of assets. On
the other hand, financing activities demonstrate how a business acquires funds and
controls its debt and equity, displaying important information about its framework and
risk management.

3.2 MEANING, SOURCES AND USES OF CASH AND ITS

USEFULNESS
MEANING OF CASH
Cash refers to physical currency, coins, and banknotes, as well as demand deposits held by
90 financial institutions. In accounting and finance, cash is a liquid asset and the most liquid
form of wealth. It includes both physical currency and money in a checking account.
 FINE005
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SOURCES OF CASH NOTES

• Operating Activities: Cash generated from day-to-day business operations, such as
sales of goods and services.
• Investing Activities: Cash received from the sale of investments or used to purchase
assets like property, plant, and equipment.
• Financing Activities: Cash obtained from or paid to investors and creditors,
including issuing or repurchasing stock, and borrowing or repaying debt.

USES OF CASH
• Operating Expenses: Payment for day-to-day business expenses like rent, salaries,
and utilities.
• Investments: Cash used for purchasing assets, securities, or making long-term
investments.
• Debt Repayment: Cash used to repay loans or other financial obligations.
• Dividends: Cash paid to shareholders as a return on their investment.
• Stock Buybacks: Cash used to repurchase shares from the open market.

USEFULNESS OF CASH
• Liquidity Assessment: Cash levels indicate a company’s ability to meet short-term
obligations without relying on external sources.
• Financial Health: Analyzing sources and uses helps evaluate a company’s financial
health and strategic priorities.
• Investor Confidence: Sufficient cash and positive cash flow can instill confidence in
investors and creditors.
• Strategic Decision Making: Understanding cash movements aids in making
informed decisions about investments, debt management, and dividends.
• Risk Management: Monitoring cash flow helps identify potential financial risks
and plan for contingencies.

3.3 WHAT IS A CASH FLOW STATEMENT

Cash is an essential resource for the operation of a business, and it is imperative that
the business generates an adequate amount of cash from its undertakings to cover its
expenditures, provide returns to investors, and expand its operations. If we want to
learn about a company’s cash management, we should look at its cash flow statement.
Comparable to a company’s financial report card, it details the inflow and outflow of cash.
It indicates whether a business is liquid relative to its expenses. Even if a business records
a profit on its income statement, it may experience cash flow issues if it fails to collect
payments from clients on time or spends excessively on new equipment.
In contrast to the income statement, which pertains to revenue generated and expenses
incurred, which may or may not have been executed in cash, the cash flow statement
exclusively discloses tangible cash movements. Unlike the statement of financial position,
which provides a momentary depiction of a firm’s financial status, the cash flow statement
monitors cash inflows and outflows throughout a specified time period (monthly, quarterly, 91
or annually).
UNIT 3
Cash Flow Statement
NOTES When it comes to compiling a cash flow statement, the terms cash and cash equivalents
are extremely important. Thus, it is critical to define and comprehend what is meant by
cash and cash equivalents.

3.3.1 OBJECTIVES OF CASE FLOW STATEMENT

• Concise Financial Liquidity Overview: Cash flow statement offers a snapshot of an
organization’s liquidity, detailing cash inflows and outflows for a specific period.
• Operational Effectiveness Evaluation: Differentiates cash flows from operating
activities, helping assess the effectiveness of fundamental business operations.
• Investment Operations Assessment: Aids investors by revealing cash allocations
to investments in assets like property, equipment, or securities.
• Detailed Financial Activities Overview: Provides insights into financing activities,
including borrowing, debt repayment, share transactions, and dividends.
• Future Cash Flow Prediction: Facilitates prediction of future cash flows, aiding in
preparation for investments or funding requirements based on observed patterns.
• Time Period Comparisons and Trend Analysis: Enables comparisons over multiple
periods, supporting trend analysis to identify significant changes in cash flow
patterns.
• Enhanced Transparency and Disclosure: Improves transparency for stakeholders,
including investors and creditors, offering a clearer view of the company’s financial
well-being.

3.3.2 DEFINING CASH AND CASH EQUIVALENTS

As previously discussed, the terms Cash and Cash equivalents are frequently used when
preparing and assessing the cash flow statement. In a cash flow statement, “cash”
refers to actual physical currency, as well as securities that are extremely liquid and
easily changeable into known amounts of currency and have a small maturity time,
typically within three months after the acquisition date. These are critical components
of a company’s financial statements because they show the amount of cash and easily
convertible assets that are accessible for immediate use in operating activities or to
satisfy short-term obligations.
Typically, cash equivalents encompass:
Cash in hand: It refers to the tangible money in the form of paper bills and metal coins
that one possesses.
Bank deposits: It Includes both current and savings accounts.
Short-term investments: It refers to highly liquid financial assets that reach maturity
within a period of three months or less from the date of acquisition.
Example: Some examples of such investments include:
• Treasury bills: Short-term government securities with maturities ranging from a
few days to 364 days.
• Certificate of deposits: A savings account that pays a set interest rate on
funds maintained for a predetermined amount of time is called a certificate of
92 deposit (CD). CDs are offered by banks as well as credit unions. Unlike regular
savings accounts, CDs include a requirement that the monies in them be kept
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undisturbed for the duration of the account, or else there will be a penalty. NOTES
Compared to savings accounts, certificate of deposit (CD) offers a greater interest
rate in exchange for a less flexible withdrawal policy.
• Money market funds: Mutual funds that invest in high-quality, short-term debt
instruments like Treasury bills, CDs, and commercial paper.
• Short-term Government Bonds: Bonds issued by governments with shorter
maturities, such as short-term municipal bonds.
• Banker’s Acceptances: A time draft drawn on a bank, representing the bank’s
unconditional promise to pay the holder a specified amount of money at a future
date.

CHECK YOUR PROGRESS – I

1. A positive cash flow means a company is profitable. And a negative cash flow means
the company is in losses.
(a) True
(b) False
2. Which financial statement is used to reconcile the opening and closing balances of
cash and cash equivalents?
(a) Profit and loss statement
(b) Statement of Financial Position
(c) Cash flow statement
(d) Statement of owners’ equity
3. The cash flow statement helps assess an organization’s capacity to produce
_____________ and manage its liquidity.
4. The cash flow statement is an optional financial statement and is not required by
accounting standards.
(a) True
(b) False
5. Which of the following is considered a cash equivalent?
(a) Inventory
(b) Marketable securities
(c) Accounts receivable
(d) Prepaid expenses

3.4 COMPONENTS OF CASH FLOW STATEMENT

Till now we have learnt that the cash flow statement is an essential financial statement
that furnishes insights into the inflow and outflow of cash within an organisation. Let us
now examine the fundamental elements that comprise a cash flow statement.
The most important elements of the cash flow statement are cash from three areas: 93
cash flow from operations, cash flow from investing, and cash flow from financing.
UNIT 3
Cash Flow Statement
NOTES Cash from operating activities records the inflows and outflows of funds generated by
routine business operations. It encompasses cash flows from core business activities,
such as revenue generation, production, and delivery of goods or services. Some elements
included in cash from operating activities are Revenue, Operating Expenses, Changes in
working capital, Cash payments for Income taxes etc.
For Example, consider a lemonade stand where revenue is generated from the sale
of lemonade; money spent on lemons or to the suppliers represents expenditures.
In addition to paying suppliers and employees salaries, operating activities also include
collecting payment from customers.
The cash from Investing activities section details the organization’s investments in
securities, property, and equipment. When an organisation purchases or sells new or
used machinery, it has an impact on its cash flow. Some elements included in cash from
investing activities are Capital Expenditures, Cash received from selling property, plant,
equipment, Investments in Marketable Securities etc.
Assume the proprietor of our lemonade stand decides to invest in an upscale new juicer.
Expenditure of money constitutes an investment activity in that purchase. If they sell their
outdated juicer, any proceeds will constitute incoming funds.
Finally, cash from financing activities pertains to the means by which an organisation
procures funds and remunerates lenders or investors. Cash flow is influenced by a
company’s dividend payments to shareholders and loan acquisitions.
In our previous example, borrowing money to expand our lemonade stand’s operations
or repaying a loan we obtained previously would constitute a financing activity. In the
event that dividends are distributed to investors, the outflow of cash would be recorded
in this.
Through the analysis of these components, investors and analysts can make well-informed
judgements regarding a company’s financial solvency, potential for expansion, and
overall efficacy. Furthermore, doing a comparison of these factors with competitors or
industry benchmarks allows for a more comprehensive evaluation of an organization’s
market position.
Cash flows are categorized as operating, investing, or financing activities on the statement
of cash flows based on the kind of transaction. Each of these three categories is defined
as follows.
• Operating Activities: Cash activities pertaining to net income are included in
operating operations. Since revenues and costs are included in net income,
cash from the sale of products (revenue) and cash spent for items (expense) are
examples of operating activities.
• Investing Activities: Cash-related noncurrent asset activities are a part of investing
activities. Long-term investments, property, plant, and equipment, and the
principal amount of loans made to other companies are examples of noncurrent
assets. This category includes, for instance, money received from the sale of land
and money invested in another business. (Take note that operating activities
include receiving interest from loans.)
• Financing Activities: Cash operations pertaining to owners’ equity and noncurrent
94 liabilities are included in the category of financing activities. Dividend payments,
stock sales and repurchases, and the principal amount of long-term debt are
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examples of noncurrent liabilities and owners’ equity items. (Note that operating NOTES
activities include interest paid on long-term debt.)

3.4.1 SUMMARY OF IAS 7

3.4.1.1 THE PURPOSE OF IAS 7
The purpose of IAS 7 is to mandate that a statement of cash flows, which categorizes cash
flows for the period in accordance with operating, investing, and financing activities, be
used to give information regarding the historical changes in cash and financial equivalents
of a business.

3.4.2.2 ESSENTIAL IDEA IN IAS 7

A statement of cash flows must be presented by every entity that prepares financial
statements in accordance with IFRSs. [IAS 7.1]
A period’s worth of changes in cash and cash equivalents are examined in the statement
of cash flows. Demand deposits, cash on hand, and short-term, highly liquid assets that
are easily convertible to a known quantity of cash and have a negligible risk of value
fluctuations are all considered cash and cash equivalents. According to guidance notes,
an investment is often considered a cash equivalent if its maturity is three months or
less from the date of acquisition. Unless they are essentially cash equivalents, equity
investments are often excluded (e.g., preferred shares bought within three months of their
stipulated redemption date). Cash and cash equivalents also include bank overdrafts that
are repayable on demand and are a crucial component of an entity’s cash management.
[IAS 7.7-8]

3.4.3.3 PRESENTATION OF THE STATEMENT OF CASH FLOWS

Cash flows must be analyzed between operating, investing, and financing activities.
[IAS 7.10]
Key principles specified by IAS 7 for the preparation of a statement of cash flows are as
follows:
• operating activities are the main revenue-producing activities of the entity that are
not investing or financing activities, so operating cash flows include cash received
from customers and cash paid to suppliers and employees [IAS 7.14]
• investing activities are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents [IAS 7.6]
• financing activities are activities that alter the equity capital and borrowing
structure of the entity [IAS 7.6]
• interest and dividends received and paid may be classified as operating, investing,
or financing cash flows, provided that they are classified consistently from period
to period [IAS 7.31]
• cash flows arising from taxes on income are normally classified as operating, unless
they can be specifically identified with financing or investing activities [IAS 7.35]
• for operating cash flows, the direct method of presentation is encouraged, but the
indirect method is acceptable [IAS 7.18]
95
UNIT 3
Cash Flow Statement
NOTES CHECK YOUR PROGRESS – II
1. The ___________ of a company’s cash equivalents at the beginning and end of the
period is essential for preparing the cash flow statement.
2. Cash flow from _____________ activities include buying and selling long-term
assets.
3. Which section of the cash flow statement typically includes changes in short-term
borrowings and issuance of stocks?
(a) Operating activities
(b) Investing activities
(c) Financing activities
(d) Net Income
4. Cash flow from operating activities includes interest and dividend income.
(a) True
(b) False
5. Cash flow from financing activities includes:
(a) Payment of dividends
(b) Purchase of inventory
(c) Sale of equipment
(d) Payment of salaries

3.5 METHODS FOR PREPARING CASH FLOW STATEMENTS

Thus far, we have comprehended that the Cash Flow statement serves as an indicator
of a company’s financial well-being, in conjunction with the balance sheet and income
statement. We also examined several components and the primary goals associated
with the creation of a cash flow statement. It is important to note that there are two
approaches (Direct and Indirect Methods) employed in the preparation of the cash flow
statement, with variations in the computation of cash flows from operating activities.

3.5.1 DIRECT METHOD

The direct cash flow method utilizes actual cash inflows and outflows derived directly
from the operational activities of the organisation. This implies that it quantifies cash
inflows and outflows at the time they are received or paid, rather than use the accrual
accounting approach. Accrual accounting acknowledges revenue as it is generated, rather
than when payment is received.
The direct method of the cash flow statement provides a concise and unambiguous
representation of a company’s cash flow. It displays the aggregate cash flow from a company’s
operations, financing activities, and investing activities within a specific timeframe. It is
beneficial for analysts and investors seeking a concise and detailed analysis of cash flows.
96 Nevertheless, the implementation of the direct method necessitates scrupulous monitoring
of individual cash inflows and outflows. This process might need a significant number
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of resources and time, particularly for larger organizations that have a high volume of NOTES
transactions. Despite the acceptance of the direct method by standard-setting bodies, its
utilization is infrequent. Compiling the information is challenging due to companies’ lack of
adherence to the necessary data collection and storage methods for this specific format.
Example:
Calculate Cash from Operations from the following information:
Table 3.1: Tables Showing Cash from Operations

Particulars Amount (Rs.)

Cash Sales 1,50,000
Credit Sales 75,000
Receivables Collections 1,50,000
Cash Purchases 35,000
Credit Purchases 40,000
Creditors Paid 87,500
General Expenses Paid 25,000
Unpaid Expenses 30,000
Wages Paid 45,000
Outstanding Wages 15,000
Salaries Paid 55,000
Total Salaries 1,25,000
Interest Received 7,500
Income Tax Paid 14,000
Depreciation 10,000
Loss due to Fire 9,000
Insurance Claims 7,500
Solution:
Amount (Rs.) Amount (Rs.)
Cash Receipts:
Cash Sales 1,50,000
Receivables collections 1,50,000 3,00,000
(Less) Cash Paid to Suppliers and Employees:
Cash Purchases 35,000
Payment to Creditors 87,500
Payment of wages 45,000
Payment of Salaries 55,000
Payment of General Expenses 25,000 2,47,500
Cash from Operations* 52,500
(Less) Payment of Income Tax –14,000
97
(Continues)
UNIT 3
Cash Flow Statement
Table 3.1: Tables showing Cash from Operations (Continued)
NOTES
Cash Flow before Extra-ordinary items 38,500
(Add) Extra-ordinary Income:
Insurance Claim received 7,500
Net Cash Flow from Operating Activities 46,000
*Only operating income and expenses are considered

3.5.2 INDIRECT METHOD

The Indirect Method is most widely used by businesses across the globe to prepare
Cash Flow Statements. This method of cash flow statement preparation determines
cash flow by modifying net income to account for non-monetary activities. A financial
statement displays the total revenue and spending of a business for a specific time frame,
together with the origins of these funds. The indirect method is applicable to accrual
basis accounting, wherein income is recognized when it is earned, regardless of when it
is actually received. This indicates that a product or service may have been billed, but the
payment has not been made yet.
The indirect approach commences with the net income figure and proceeds to make
necessary changes in order to align it with the cash flows originating from operational
operations. This methodology is comparatively more straightforward and efficient than
the direct method, as it eliminates the need for monitoring individual cash transactions.
Furthermore, it adheres to established accounting practices and standards, facilitating
comparison across the financial statements of various organizations. However, it doesn’t
offer a detailed breakdown of specific cash receipts and payments within operating
activities. This lack of detail might limit the insight into the specific drivers of cash flow
changes. As a result, the indirect approach may not offer sufficient specific information
for thorough analysis in comparison to the direct method, which provides a more detailed
perspective on cash transactions.

Let us look at the example:

Statement of Profit and Loss Account for the year ended March 31, 2017
Table 3.2: Statement of Profit and Loss Account

Particulars Note Amount (Rs.)

(i) Revenue from Operations 1,00,000
(ii) Other Income 1 2,000
(iii) Total Revenues (i + ii) 1,02,000
(iv) Expenses
Cost of Materials Consumed 30,000
Purchases of stock-in-trade 10,000
Employees Benefits Expenses 10,000
Finance Costs 5,000
Depreciation 5,000
98 Other Expenses 12,000
(Continues)
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Table 3.2: Statement of Profit and Loss Account (Continued)
NOTES
72,000
(v) Profit before Tax (iii − iv) 30,000
Note: Other income includes profit on sale of land.
The Statement of Profit and Loss above displays a net profit amounting to Rs. 30,000.
To determine cash flows from operating activities, adjustments need to be made for
various items.
Let’s examine various items affecting cash flows:
• Depreciation, a non-cash item, amounts to Rs. 5,000 and does not impact cash
flow. Therefore, this sum should be added back to the net profit.
• Finance costs of Rs. 5,000 represent a cash outflow related to financing activities.
Consequently, this amount should be added back to the net profit when computing
cash flows from operating activities. This finance cost will be recorded as an outflow
under financing activities.
• Other income encompasses profit from the sale of land: It constitutes a cash inflow
from investing activities. Thus, this figure should be subtracted from the net profit
amount when determining cash flows from operating activities.

In accordance with AS-3, under the indirect method, net cash flow from operating activities
is calculated by adjusting net profit or loss for the impact of:
• Non-cash items such as depreciation, goodwill written-off, provisions, deferred
taxes, etc., which are added back.
• All other items for which the cash effects are investing or financing cash flows.
The treatment of such items depends on their nature. All investing and financing
incomes are deducted from the net profit, while all such expenses are added back.
For instance, finance cost, a financing cash outflow, is added back, while other
income such as interest received, an investing cash inflow, is deducted from the
net profit. Dividend declared is considered a financial activity and is therefore
added back to net profit, shown as an outflow under financial activity.
• Changes in current assets and liabilities during the period. Increase in current
assets and decrease in current liabilities are deducted, while an increase in current
liabilities and decrease in current assets are added up.
Example: Cash Flow from Investing Activities
Welprint Ltd. has provided the following information:
Table 3.3: Tables Showing Cash Flow from Investing Activities

Rs.
Machinery as on April 01, 2012 50,000
Machinery as on March 31, 2013 60,000
Accumulated Depreciation on April 01, 2012 25,000
Accumulated Depreciation on March 31, 2013 15,000
99
During the year, a Machine costing Rs. 25,000 with Accumulated Depreciation of Rs. 15,000
was sold for Rs. 13,000.
UNIT 3
Cash Flow Statement
NOTES Calculate cash flow from Investing Activities from the above information.
Solution:
Cash Flows from Investing Activities Rs.
Sale of Machinery 13,000
Purchase of Machinery (35,000)
Net cash used in Investing Activities (22,000)

Working Notes:
Dr. Machinery Account Cr.
Particulars J. F Amount (Rs.) Particulars J. F Amount (Rs.)
Balance b/d 50,000 Cash (proceeds from 13,000
sale of machine)
Statement of Profit and 13,000 Accumulated
Loss (profit on sale of Depreciation 15,000
machine)
Cash (balancing 35,000 Balance c/d 60,000
figure: new machinery
purchased)
88,000 88,000

Dr. Accumulated Depreciation Account Cr.

Particulars J. F Amount (Rs.) Particulars J. F Amount (Rs.)
Machinery 15,000 Balance b/d 25,000
Balance c/d 15,000 Statement of Profit and Loss 5,000
(Depreciation provided during
the year)
30,000 30,000

Example: Cash Flow from Financing Activities

The cash transactions of XYZ Ltd are taken from their books. It is obligated to create a cash
flow statement for the period ending on March 31, 2020, following Accounting Standard-3
(Revised).
Table 3.4: Tables Showing Cash Flow Statement for the period ending 31st March 2020

Particulars Amount (Rs. ‘000)

Balance as on 1st April 2019 140
Receipts from customers 11132
Issue of shares 1200
Sale of fixed assets 512
12984
Payments to suppliers 8188
100
Payments for fixed assets 920
(Continues)
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Table 3.4: Tables Showing Cash Flow Statement for the period ending 31st March 2020 (Continued)
NOTES
Payments for overheads 460
Wages and salaries 276
Taxation 972
Dividends 320
Repayment of bank loans 1000
12136
Balance as on 31st March, 2020 848
Solution:
Cash Flow Statement for the period ending 31st March 2020

Particulars Amount (Rs. ‘000)

A. Cash Flow from Operating Activities
Receipts from customers 11132
Payment to suppliers (8188)
Payment of Wages and Salaries (276)
Payment of Overheads (460)
Payment of Taxes (972)
Net Cash from Operating Activities(A) 1236
B. Cash Flow from Investing Activities
Proceeds on sale of fixed assets 512
Acquisition of (payments) fixed assets (920)
Net Cash Used in Investing Activities (B) (408)
C. Cash Flow from Financing Activities
Proceeds on issue of shares 1200
Payments of dividends (320)
Repayments of bank loans (1000)
Net Cash Used in Financing Activities (C) (120)
Net increase in cash and cash equivalents (A)+(B)+(C) 708
Cash and cash equivalents at the beginning of the period 140
Cash and cash equivalents at the end of the period 848
Example:
Prepare the Cash Flow Statement using indirect methods, using the Profit and Loss account
and Balance Sheet provided below:
Profit and Loss Account for the year ended 31st March 2021 (Rs. in Thousands)
Table 3.5: Profit and Loss Account for the year ended 31st March 2021

Year 2020–21 Year 2019–20

Sales 111780 98050
Other Income 390 220
Cost of Goods sold 41954 39010 101
Selling and Distribution Expenses 16178 12500
(Continues)
UNIT 3
Cash Flow Statement
NOTES Profit Before Tax 54038 46760
Less Income Tax 21615 18704
Profit After Tax 32423 28056

Balance Sheet as on 31st March 2021 (Rs. In thousands)

Table 3.6: Balance Sheet as on 31st March 2021

Liabilities and Shareholder Equity As on 31-3-21 As on 31-3-20

Equity Share Capital 180000 180000
Retained Earnings 134045 101622
Current Liabilities
Accounts Payable 3526 4330
Income Tax Payable 21615 –
Dividend Payable – 25000
Total Liabilities 339186 310952
Assets
Fixed Assets 393000 (370000)
Less: Depreciation 92400 (90000) 300600 280000
Current Assets 6380 6000
Cash
Accounts Receivable: 20064
Less: Provision — (972) 19092 23568
Inventory: Raw Materials 516 636
Finished Good 598 748
Investments 12000 –
Total Assets 339186 310952

Solution:
Cash Flow Statement Under Indirect Method/as per Listing Agreement
Table 3.7: Cash Flow Statement Under Indirect Method/as per Listing Agreement

A. Operating Activities
Profit After Tax or Net Income
Adjustments for: 32423
Depreciation 2400
Trade Receivables 4476
Inventories 270
Income Tax 21615
102 Accounts Payable (804) 27957
Net Cash from Operating Activities 60380
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B. Investment Activities NOTES

Purchase of Plant Assets (23000)
Short-term investments (12000)
Net Cash from Operating Investments (35000)
C. Financing Activities
Dividends Paid (25000)
Net Cash Flow from Financing Activities (25000)
D. Net Change in Cash 380
Cash at the Beginning of the year 6000
Cash at the End of the Year 6380
The aforementioned example illustrates the adjustments made to the net profit/loss
amount. Other crucial adjustments pertain to changes in working capital, essential for
converting net profit/loss, based on accrual basis, into cash flows from operating activities.
Hence, the increase in current assets and decrease in current liabilities are subtracted
from the operating profit, while the decrease in current assets and increase in current
liabilities are added to the operating profit to determine the precise net cash flow from
operating activities.

CHECK YOUR PROGRESS – III

1. Why is the cash flow statement important for stakeholders?
(a) It helps in assessing a company’s potential market share.
(b) It aids in understanding a company’s ability to pay dividends and debts.
(c) It determines the company’s return on investment.
(d) It showcases the company’s manufacturing efficiency.
2. Which method is commonly used for its transparency and direct presentation of
cash movements?
(a) Indirect method
(b) Hybrid method
(c) Direct method
(d) Modified method
3. The direct method requires adjustments for non-currency items to Conciliate net
income to cash flows from operating activities.
(a) True
(b) False
4. The __________ method begins with net income and then adjusts it to calculate
cash flows from operations.
5. The __________ method of preparing the cash flow statement directly lists cash
inflows and outflows from operating activities.
103
UNIT 3
Cash Flow Statement
NOTES 3.6 ANALYSIS OF CASH FLOW STATEMENT
A cash flow statement might illustrate one of eight possible scenarios. The eight situations
are interpreted in the table below.
Table 3.8: Cash Flow from Activities

Operating Investing Financing Interpretation

+ + + The company accumulates cash through operational
income, asset sales, and financing, indicating a high
level of liquidity. This suggests that the company may
be considering an acquisition.
+ − − The company utilizes cash generated from
operations for acquiring fixed assets and settling
debts or distributing payments to owners.
+ + − The company utilizes cash generated from operations
and the sale of fixed assets to reduce debt or
compensate owners.
+ − + The corporation use cash flow from activities,
borrowings, or owner investments to expand by
investing in long-term assets.
− + + The corporation addresses its operating cash flow
issues by selling fixed assets and obtaining funds
through borrowing or contributions from shareholders.
− − + The firm is experiencing significant growth but is facing
deficiencies in cash flows from operations and from the
acquisition of fixed assets, which are being funded by
long-term debt or fresh investments.
− + − The corporation is covering deficits in operating
cash flow and making payments to creditors and
stockholders by selling fixed assets.
− − − The corporation utilizes cash reserves to fund
operational deficits, finance its fixed assets, and
make payments to long-term creditors and investors.

3.7 CASH FLOW ANALYSIS

So far, we learnt that Cash flow refers to the total amount of cash and cash equivalents,
including securities, that a business generates or expends within a specified timeframe.
We also underwood that Cash flow statement Analyzing a cash flow statement is crucial
for understanding a company’s financial health and how effectively it manages its cash.
Now let us discuss what is cash flow analysis. As previously stated, Companies should
keep track of and study three types of cash flow to find out how liquid and solvent their
business is:
1. cash flow from operating activities

104 2. cash flow from investing activities, and

3. cash flow from financing activities.
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When doing a cash flow analysis, firms examine the line items in the three cash flow NOTES
categories to determine the sources and uses of cash. Based on this, they can infer
insights into the present liquidity condition of the business.
Cash flow analysis provides insight into the amount of cash that a business earned or
utilized within a designated accounting period. In addition, gaining insight into the origins
of cash inflows and tracking the destinations of cash outflows is crucial for ensuring the
long-term financial viability of an organisation. However, one must note that a business
might generate profits while simultaneously facing negative cash flow or incur losses
while experiencing positive cash flow.

3.7.1 CASH FLOW FROM OPERATING ACTIVITIES ANALYSIS

Imagine for a moment that the cash flow statement of a business is being examined.
The cash flow is composed of three parts, as we have just covered in the previous section.
The cash flow from operating activities comes first. Let’s examine how to analyze operating
cash flows, both positive and negative. Comprehending the cash flow from operating
operations entails grasping the meaning of the data and their reflection of a company’s
financial well-being.
Positive operating cash flow refers to the situation where a company’s cash inflows from
its core operations exceed its cash outflows. A consistently favourable cash flow from
operations signifies that the company’s fundamental business is producing more money
than it is expanding. This indicates robust activities and a positive indication of financial
stability. It also indicates the company’s capacity to meet its daily expenses, including
payroll, inventories, and operational costs, without significant reliance on external funding
or borrowing.
Conversely, negative operating cash flow can often arise as a result of temporary factors
such as significant investments in expansion, acquisitions, or substantial research and
development costs. It does not necessarily imply a state of inadequate financial well-being.
Nevertheless, if there is a continued occurrence of negative operating cash flow over
multiple periods without a distinct justification or plan, it may indicate financial strain and
an incapacity to maintain essential business activities.
It is essential to compare the operating cash flow throughout multiple periods. Steady
expansion in cash flow indicates enhanced financial well-being, however decreasing
or variable cash flow may give rise to apprehensions. It is important to consider the
fluctuations that occur with the changing seasons.
For example, retail organizations may have increased cash inflows during holiday seasons.
Gaining insight into these patterns facilitates precise interpretation of the data.

3.7.2 CASH FLOW FROM INVESTING ACTIVITIES ANALYSIS

Analyzing cash flows, both positive and negative, arising from investing activities offers
valuable insights into a company’s approach to managing its asset investments and
long-term expansion. This Positive cash flows from investments pertain to the receipt
of cash generated by the purchase, sale, or divestment of company-held long-term
assets or investments. These investments may involve the acquisition or disposal of real
estate, machinery, equipment, stocks, or other business opportunities with the aim of
achieving long-term growth or generating revenue. A positive cash flow from investments 105
signifies that the company’s investment endeavors are yielding returns that surpass the
UNIT 3
Cash Flow Statement
NOTES initial investment cost. The increase in funds can arise from several origins, including the
liquidation of underperforming assets, the reception of dividends or interest income from
investments, or the realization of profits from the sale of securities.
Positive cash flows from investments demonstrate the company’s skill in efficiently using
its resources to create value for shareholders and stakeholders, hence enhancing overall
financial well-being and long-term viability. Furthermore, they offer valuable information
on management’s strategic choices for the distribution of funds and investment plans,
which might have an effect on the company’s future development potential and
profitability.
However, negative cash flow could mean that the firm gives out in investments (property,
plant and equipment), rather than in sales of assets. This may be telling of growth
aspirations or heavy capital investment. Another interpretation is that the company is
funding its investments through debt or financing operations.

3.7.3 CASH FLOW FROM FINANCING ACTIVITIES ANALYSIS

Cash flow from financing activities is a crucial component of the cash flow statement that
outlines the cash transactions associated with a company’s financing sources. This category
includes activities that involve the company’s capital structure, such as debt, equity, and
dividend-related transactions. Positive cash flow from financing activities indicates that
the company is raising capital, either through borrowing or issuing equity. On the other
hand, negative cash flow suggests repayment of debt or shareholder distributions.
The analysis of cash flow from financing activities provides valuable insights into a
company’s financial structure and how it manages its capital. By examining this section,
investors and analysts can assess the company’s ability to meet its financial obligations, its
approach to funding operations, and its commitment to returning value to shareholders
through dividends or share repurchases. A careful examination of financing activities helps
stakeholders understand the overall financial health of the company and its strategies for
maintaining a balanced capital structure.

CHECK YOUR PROGRESS – IV

1. Increased cash inflow from operating activities indicates:
(a) The company is profitable
(b) The company is facing financial distress
(c) The company’s stock price will decrease
(d) The company is facing liquidity issues
2. Positive cash flow indicates that a company has enough _______ to cover its
obligations and invest in growth.
3. An increase in accounts receivable would usually result in:
(a) An improvement in cash flow from operations
(b) A reduction in cash flow from operations
(c) No impact on cash flow from operations
106
(d) An increase in cash flow from financing activities
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4. What does a decrease in inventory indicate regarding cash flow from operating NOTES
activities?
(a) Improvement in cash inflow
(b) reduction in cash flow
(c) No impact on cash flow
(d) Negative impact on cash flow
5. _______ activities involve transactions related to debt, equity, and dividends.

3.8 SIGNIFICANCE OF CASH FLOW ANALYSIS

Many financial professionals, analysts, and investors believe cash flow analysis to be vital
due to the valuable and distinct insights it provides.
• Cash flow analysis provides a comprehensive overview of the incoming and
outgoing cash, determining the ability of a company to fulfil its immediate financial
responsibilities. It facilitates comprehension of the amount of liquid funds
accessible for immediate requirements.
• Examining the progression of cash flow enables the evaluation of a company’s
fiscal well-being. A consistent positive cash flow signifies financial stability and the
capacity to reinvest, whereas negative cash flow may suggest financial difficulties.
• Investors employ cash flow analysis to assess the prospective gains and hazards
associated with investing in a firm. A favourable cash flow is frequently regarded
as an indication of a sound investment.
• It facilitates the process of budgeting and strategizing for forthcoming
expenditures. Comprehending the patterns of cash flow enables organizations to
make well-informed decisions regarding expenditure, expansion, or investment in
new ventures.
• Creditors and financiers employ cash flow analysis to assess a business capacity to
repay loans. Having a surplus of cash inflow enhances one’s creditworthiness and
has the potential to result in more favourable lending conditions.
• It facilitates the formulation of strategic decisions, such as determining whether
to expand, invest in new equipment, or modify operations in order to improve
cash flow.

3.8.1 LIMITATIONS OF CASH FLOW ANALYSIS

Till now, we have discussed the meaning and significance of cash flow analysis.
Now, comprehend various limitations of cash flow analysis. As we know, every stable
business starts with an understanding of the complex dynamics of financial health.
Cash flow analysis is an essential tool for assessing a business financial position by
examining the movement of currency in and out of the business. However, it’s crucial to
know its disadvantages to ensure a comprehensive understanding of a company’s financial
position. Here are several constraints commonly associated with cash flow analysis:
1. Cash flow analysis ignores non-cash components like depreciation, which
affects profitability but doesn’t involve actual cash transactions, in favor of only
107
analyzing cash movements.
UNIT 3
Cash Flow Statement
NOTES 2. Financial stability may be misrepresented by the timing of cash flows. A company’s
high cash flow during a given period may give the impression that it is healthy,
but this could be a one-time occurrence, clouding the assessment.
3. Changes in working capital may not be sufficiently captured by cash flow analysis.
A company may have strong cash flow but be having trouble because of higher
inventory or accounts receivable.
4. It may not distinguish between cash flows originating from financing, investing,
and operating operations. This makes it more difficult to identify the sources and
uses of cash, which has an impact on a company’s overall financial operations.
5. Since cash flow analysis is historical, it cannot reliably forecast performance in
the future. It could not be indicative of future adjustments to the business plan
or the state of the market.
6. Businesses can manipulate cash flow in a number of ways, such as by speeding
up or delaying receivables, to appear as though the company is doing well.
7. Different industries have unique cash flow patterns, making comparisons
between them challenging and potentially misleading.
8. The evaluation as a whole may be impacted if some financial flows—particularly
those that are not directly connected to operations, investments, or financing—
are not included in the analysis.

CHECK YOUR PROGRESS – V

1. The cash flow statement primarily deals with the timing of cash flows rather than
the actual amounts.
(a) True
(b) False
2. Which activity is considered a financing activity in cash flow analysis?
(a) Purchasing inventory
(b) Issuing bonds payable
(c) Collecting accounts receivable
(d) Paying salaries to employees
3. The cash flow statement helps in:
(a) Assessing profitability only
(b) Evaluating liquidity and solvency only
(c) Understanding changes in cash and cash equivalents
(d) Summarizing all financial transactions
4. Cash flow from ____________ activities involve acquiring and disposing of long-
term assets.
108 5. Cash equivalents are highly ____________ and easily convertible into cash.
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3.9 CASE STUDY ON CASH FLOW ANALYSIS NOTES

The cash flow of NTPC Ltd over a period of three years is presented below. Form a cohort
consisting of the peers and analyze the data from different years, comparing the results
from one year to another.
Additionally, provide an analysis of the fluctuations in cash flows across different activities.
Additionally, analyze the factors contributing to the observed rise or decline. The following
table shows the comparative cash flow statement of NTPC Ltd:
Table 3.9:Comparative Cash Flow Statement of NTPC Ltd

Particulars Amount (Rs.) Amount (Rs.) Amount (Rs.)

March 2020 March 2019 March 2018
Net Profit/Loss Before Extraordinary 20,317.07 7,776.05 12,339.46
Items and Tax
Net Cash Flow from Operating Activities 22,014.26 16,030.47 19,248.35
Net Cash Used in Investing Activities −27,677.12 −20,894.22 −20,388.19
Net Cash Used from Financing Activities 5,658.88 4,827.65 1,043.21
Foreign Exchange Gains/Losses −0.03 −0.01 0
Net Inc/Dec In Cash And Cash Equivalents −4.01 −36.11 −96.63
Cash And Cash Equivalents Begin of Year 24.38 60.49 157.12
Cash And Cash Equivalents End of Year 20.37 24.38 60.49
*Source: https://www.moneycontrol.com/financials/ntpc/cash-flowVI/NTP#NTP

CASE STUDY – 2
With over 85 years of heritage in India, Synergy Corporation is India’s largest fast-moving
consumer goods company. On any given day, nine out of ten Indian households use
our products, giving us a unique opportunity to build a brighter future. We are known
for our great brands, the positive social impact we create, and our belief in doing business
the right way. Synergy Corporation works to create a better future every day and helps
people feel good, look good, and get more out of life with brands and services that are
good for them and good for others.
Let’s learn Cash Flow Statement analysis through Synergy Corporation’s Cash Flow
Statement and assess the Cash position of Synergy Corporation in 2020 versus 2019.
The Synergy Corporation’s Cash Flow Statement as of March 31, 2020, and March 31,
2019, has been provided below:
Table 3.10: Statement of Cash Flows for the year ended 31st March, 2020 (……Rs. In Crore……)

Particulars 2020 2019

Operating Activities:
Net Profit 500 450
Add: Depreciation 150 130
Add: Decrease in Accounts Receivable 50 40
Less: Increase in Accounts Payable (30) (20) 109
UNIT 3
Cash Flow Statement
NOTES Operating Cash Flow 670 600
Investing Activities:
Purchase of Property, Plant, and Equipment (200) (180)
Purchase of Investments (100) (90)
Sale of Investments 50 30
Investing Cash Flow (250) (240)
Financing Activities:
Repayment of Long-term Debt (50) (40)
Issuance of Equity 100 90
Dividends Paid (80) (70)
Financing Cash Flow (30) (20)

Interpretation:
• Operating Activities: The operating cash flow increased from Rs. 600 crores in 2019
to Rs. 670 crores in 2020, indicating improved cash generation from the company’s
core operations.
• Investing Activities: The company invested Rs. 200 crores in property, plant, and
equipment in 2020 compared to Rs. 180 crores in 2019. Additionally, investments
in securities increased from Rs. 90 crores in 2019 to Rs. 100 crores in 2020. Despite
higher investments, the company managed to generate cash through the sale of
investments, resulting in a net cash outflow of Rs. 250 crores in 2020 compared to
Rs. 240 crores in 2019.
• Financing Activities: Synergy Corporation repaid Rs. 50 crores of long-term debt
in 2020 compared to Rs. 40 crores in 2019. Equity issuance increased from Rs. 90
crores in 2019 to Rs. 100 crores in 2020. However, dividends paid also increased
from Rs. 70 crores in 2019 to Rs. 80 crores in 2020, resulting in a net cash outflow
of Rs. 30 crores in 2020 compared to Rs. 20 crores in 2019.
• Net Increase (Decrease) in Cash: The company experienced a net increase in cash
of Rs. 390 crores in 2020 compared to Rs. 340 crores in 2019. This indicates an
improved cash position for Synergy Corporation in 2020 compared to the previous
year, reflecting its ability to generate cash from operating activities despite
increased investments and dividend payments.

3.10 LET US SUM UP

The cash flow statement is a vital tool that unveils the financial intricacies of a business,
providing a comprehensive overview of the cash movement in and out of an organisation.
It serves as a financial compass, elucidating the company’s financial health and operational
efficiency. Comprising three main sections—operating, investing, and financing activities—
the cash flow statement delineates how cash and cash equivalents traverse within the
company.
Cash flow from operating activities captures the day-to-day cash generated or spent
through routine business operations. This section encompasses revenue, operating
110 expenses, changes in working capital, and tax payments. Analyzing this segment unveils
insights into a company’s core operations, showcasing its ability to generate cash
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independently of external financing sources. For instance, a positive operating cash NOTES
flow indicates robust revenue generation and efficient management of operational
expenses.
The cash flow from investing activities details the organization’s investments in long-
term assets, like Assets, infrastructure, and machinery. Purchases or sales of these
assets significantly impact the cash flow. Investment in assets reflects the company’s
growth strategies and plans for future expansion. Understanding this segment aids in
assessing the company’s capital allocation decisions and its commitment to long-term
growth.
Meanwhile, cash flow from financing activities reveals how a company raises and
manages funds. It involves activities related to debt, equity, and dividend payments.
Borrowing money for expansion, repaying loans, issuing shares, or paying dividends are
reflected here. This section helps in understanding the company’s capital structure, risk
management, and dividend policies.
The cash flow statement is pivotal for stakeholders as it provides valuable insights.
Investors, analysts, and creditors utilise it to assess a company’s liquidity, solvency, and
overall financial performance. By examining cash flows over time, they discern patterns
indicating financial stability or potential distress. Moreover, it aids in predicting future
cash flows, guiding investment decisions and strategic planning.
Cash and cash equivalents, integral to the cash flow statement, encompass highly liquid
assets such as cash in hand, bank deposits, and short-term investments. These assets can
be converted into known amounts of money in a short period of time, usually no more
than three months. They paint an accurate depiction of the business’s immediate liquidity
and ability to meet obligations.
However, despite its significance, the cash flow statement has limitations. It focuses
solely on cash transactions, disregarding non-cash components like depreciation,
which affects profitability. Fluctuations in cash flow might misrepresent a company’s
actual financial status, while changes in working capital might not be fully captured.
Additionally, it may not distinguish between cash flows from different operational areas,
making it challenging to identify sources and uses of cash accurately.
In essence, while the cash flow statement offers valuable insights into a company’s financial
health, stakeholders must complement this analysis with other financial statements and
variables to gain an in-depth awareness of the business’s financial health and prospects
for growth in the future.

3.11 KEYWORDS
Cash: Cash refers to physical currency in the form of coins and banknotes that hold
immediate value and are readily acceptable as a medium of exchange for goods and
services. It’s a tangible asset that individuals and businesses use for transactions.
Cash Equivalents: Currency equivalents are extremely liquid securities that are easily
changeable into known amounts of currency and have a short maturity period, usually
three months or less from the date of acquisition. They are recognized as part of an
organization’s cash reserves because of their close similarity to cash.
Cash Flow: The term “Cash flow” refers to the movement of currency into and out of an 111
organisation over a certain time period, typically a month, quarter, or year. It represents
UNIT 3
Cash Flow Statement
NOTES the inflow and outflow of currency and currency equivalents, indicating how funds are
generated and used within an organisation.
Cash Flow Statement: A cash flow statement is a financial document summarizes the
amount of cash and its equivalent that enter and leave a business during a given period.
It presents a comprehensive view of a company’s cash flow activities, focusing on three
main categories: operations, investments, and financing activities.
Operating Activities: This element of the cash flow statement illustrates currency
produced or used in day-to-day business operations. It includes transactions related
to revenue, expenses, and changes in working capital like receivables, payables, and
inventory.
Investing Activities: This part shows cash flows from the buying and sale of long-term
assets, such as machinery, land, and infrastructure. It encompasses capital expenditures,
acquisitions, and disposals of assets.
Financing Activities: Here, the cash flow statement documents transactions involving the
company’s capital structure. It includes activities related to obtaining or repaying capital,
such as distributing or purchasing back shares, obtaining, or paying back loans, and paying
payouts for dividends.

3.12 REFERENCES AND SUGGESTED ADDITIONAL READING

REFERENCE
1. Shette, R. (2018). Earnings Management to Avoid Losses: Evidence from India (No. 255).

SUGGESTED ADDITIONAL READING

1. Klammer, T. (2018). Statement of Cash Flows: Preparation, Presentation, and Use.
John Wiley & Sons.
2. Rajasekaran, V. (2011). Financial accounting. Pearson Education India.
3. Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2022). Financial accounting theory
and analysis: text and cases. John Wiley & Sons.

3.13 SELF-ASSESSMENT QUESTIONS

1. Which of the following is not a component of cash flow?
(a) Operating activities
(b) Financing activities
(c) Accrued expenses
(d) Investing activities
2. Cash flow from operating activities includes:
(a) Cash inflows and outflows from issuing stocks
(b) Cash inflows and outflows from investing in securities
(c) Cash inflows and outflows from day-to-day business operations
112
(d) Cash inflows and outflows from repaying loans
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3. Which financial statement provides information about cash flows during a specific NOTES
period?
(a) Income statement
(b) Balance sheet
(c) Statement of cash flows
(d) Statement of retained earnings
4. A company’s cash flow statement helps in assessing its:
(a) Profitability
(b) Liquidity
(c) Solvency
(d) All of the above
5. Cash flow to creditors is a part of:
(a) Operating activities
(b) Financing activities
(c) Investing activities
(d) None of the above
6. An increase in accounts receivable would typically:
(a) Increase cash flow from operating activities
(b) Decrease cash flow from operating activities
(c) Have no impact on cash flow from operating activities
(d) Impact cash flow from investing activities
7. Which cash flow category involves the purchase or sale of long-term assets?
(a) Operating activities
(b) Financing activities
(c) Investing activities
(d) Accrual activities
8. Net income can be found in which section of the cash flow statement?
(a) Operating activities
(b) Investing activities
(c) Financing activities
(d) None of the above
9. Which method is used to prepare the cash flow statement?
(a) Direct method
113
(b) Indirect method
UNIT 3
Cash Flow Statement
NOTES (c) Both direct and indirect methods
(d) None of the above
10. Cash flow analysis is crucial for:
(a) Assessing a company’s ability to pay its debts
(b) Predicting future financial performance
(c) Evaluating cash inflows and outflows
(d) All of the above

3.14 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. False
2. C
3. Cash
4. False
5. B

Check Your Progress – II

1. balance
2. Investing
3. Financing
4. False
5. Payment of dividends

Check Your Progress – III

1. B
2. C
3. False
4. Indirect
5. Direct

Check Your Progress – IV

1. A
2. Liquidity
3. B
4. A
5. Financing
114
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Check Your Progress – V NOTES

1. True
2. B
3. C
4. Financing
5. Liquid

3.15 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) Accrued expenses
2. (c) Cash inflows and outflows from day-to-day business operations
3. (c) Statement of cash flows
4. (d) All of the above
5. (b) Financing activities
6. (a) Increase cash flow from operating activities
7. (c) Investing activities
8. (a) Operating activities
9. (c) Both direct and indirect methods
10. (d) All of the above

115
 UNIT 4
VALUATION

STRUCTURE
4.0 Objectives
4.1 Introduction
4.2 Concept of Valuation
4.3 Introduction to Absolute Valuation
4.4 Concept of Intrinsic Value
4.5 Introduction to Relative Valuation
4.6 Replacement Cost Method of Valuation
4.7 Liquidation Value
4.8 Factors Affecting Valuation
4.9 Challenges to Valuation
4.10 Let Us Sum Up
4.11 Keywords
4.12 References and Suggested Additional Reading
4.13 Self-Assessment Questions
4.14 Check Your Progress – Possible Answers
4.15 Answers to Self-Assessment Questions

4.0 OBJECTIVES
After reading this unit, the student should be able to:
1. define value and distinguish absolute and relative methods.
2. explain how intrinsic value determines asset value.
3. apply the replacement cost technique to assess asset value and its practical
implications.
4. examine how liquidation value affects financial decisions during tough times.
5. analyse how a sum of parts valuation can reveal an entity’s whole value.
6. consider market conditions, economic effects, industry variables, company-specific
elements, and valuation process defects affecting value.
117
UNIT 4
Valuation
NOTES RECAP OF UNIT 3
In the previous chapter, we have discussed in detail about the “Cash Flow Statement”
and developed a comprehensive explanation of the concept, origins, and applications
of cash, emphasizing its importance in financial management. We also gained valuable
information about the mechanisms by which businesses create and use cash, emphasizing
the vital importance of cash flow for long-term profitability better functioning of the firms.
The chapter also talked about the importance of cash flow statements in making financial
decisions and strategic planning. Additionally, the chapter gave valuable inputs to help
determine the ability of a company to meet immediate financial obligations while also
making expansion investments. In a nutshell, the chapter highlighted the significance of
the Cash Flow Statement for financial analysis and decision support.
Let us now move ahead with the concepts of valuation.

4.1 INTRODUCTION
Valuation is a fundamental concept in finance and investment, and it is used to value
assets, securities, and organizations. A systematic procedure for valuing an asset
or an organization assists investors, analysts, and stakeholders in making informed
decisions. This principle makes use of both absolute and relative valuation. To assess
the worth of an asset, absolute valuation evaluates cash flows, profitability, and
growth potential. Price-to-earnings ratios are used in relative valuation to compare
an asset to market peers. The Liquidation Value—the estimated earnings from selling
assets in a liquidation sale—is critical in bad circumstances. The Replacement Cost
Method, on the other hand, emphasizes the cost of replacing an item at market
value. Components in total Deconstructing a corporation and assigning values to
each component is a time-consuming valuation process. Even with systematic
frameworks in place, market conditions, economic trends, industry dynamics, and
company-specific variables all have an impact on valuation complexity. To overcome
uncertainties, information gaps, and behavioural biases in evaluation, strategic
thinking is required. Valuation is a vast discipline that has an impact on financial
decisions. It requires evaluating assets and enterprises in an ever-changing financial
environment.

4.2 CONCEPT OF VALUATION

Valuation in finance and investment refers to determining the worth of an asset, security, or
business. The intrinsic worth of an asset represents its economic value and aids in making
educated decisions. Consider evaluating the stock value of a publicly traded corporation.
Stock Value are calculated by investors using financial facts, growth projections, and
industry comparisons. Some evaluation tools are used by investors to determine whether
the market price corresponds to the fundamentals and predicted earnings. Outside of
the stock market, valuation influences mergers and acquisitions, financial reporting, and
strategic planning. Based on an adequate mergers assessment, the buying company pays
a reasonable price for the target company. Organisations use valuation methodologies to
assess the fair worth of assets and liabilities, assuring balance sheet correctness. Valuation
is required for complex financial decisions since it carefully assesses the worth of various
assets in various scenarios.
118 For a better understanding, let us look for some important definitions on valuation given
by the experts.
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4.2.1 DEFINITION OF VALUATION NOTES
“The activity or practice of determining the worth of a business, ownership stake in a
business, security, or intangible asset is referred to as valuation.” Shannon Pratt, Business
Valuation Expert.
“A collection of systematic processes used to determine the monetary value of a
corporation is referred to as valuation. These approaches are used by business appraisers
to assess the value at which a business will be transferred from a willing buyer to a willing
seller, both of whom have a sufficient comprehension of the relevant information.” James
Hitchner, Financial Valuation Expert.

4.2.2 IMPORTANCE OF VALUATION IN DECISION-MAKING

We shall now discuss the significance of valuation in making effective decisions.
Investment, mergers and acquisitions, financial reporting, and strategic planning decisions
all rely on valuation. The significance of valuation can be demonstrated in several ways:
1. Informed Investment Decisions
Valuation provides investors with crucial insights into the potential return and
risk associated with an investment. Whether in stocks, bonds, or other financial
instruments, understanding the intrinsic value helps investors make informed
decisions, aligning their investment choices with their risk tolerance and
financial objectives.
2. Mergers and Acquisitions
Valuation aids in merger and acquisition negotiations by ensuring that the
purchase price corresponds to the target company’s value. Precise evaluation
reduces overpayment or underpayment, assisting merged companies in
achieving success and longevity.
3. Financial Reporting Accuracy
Valuation supports businesses in assessing the values of their assets and
liabilities for financial reporting purposes. To comply with accounting rules and
regulations, financial statements must accurately portray the organization’s
financial status.
4. Strategic Planning
Valuation provides a thorough financial insight for strategic planning. An accurate
value evaluation enables businesses to improve their performance, allocate
resources more effectively, and make educated decisions about future
investments and operational plans.
5. Capital Budgeting and Resource Allocation
The importance of valuation in capital planning and resource allocation is
critical. This technique supports firms in allocating resources to initiatives that
match with their strategic objectives and give the best risk-adjusted returns by
analysing investment possibilities.
6. Risk Management
Effective risk management requires value. Companies can detect and mitigate
risks by understanding asset and liability assessments. This is required in 119
industries with volatile asset values or markets.
UNIT 4
Valuation
NOTES 7. Investor and Stakeholder Confidence
Increased precision and clarity in valuation instils greater trust in investors
and stakeholders. Instilling trust in an organization’s impartiality, equity,
and precision of appraisals creates trust and increases its credibility among
investors, lenders, and other stakeholders. Valuation is a systematic and
unbiased method of estimating the worth of an asset. It aids in the direction
of decisions that affect the financial well-being and strategic trajectory of
individuals and organizations.

4.2.3 APPROACHES TO VALUATION

After understanding the significance of valuation, it is now essential to discuss the crucial
approaches to valuation.
Absolute valuation and relative valuation are two distinct approaches used in financial
analysis. Absolute valuation involves assessing the intrinsic value of an asset or security
based on its fundamental characteristics, cash flows, and other relevant factors.
Common methods in absolute valuation include discounted cash flow (DCF) analysis and
the dividend discount model (DDM). On the other hand, relative valuation compares
the subject asset or security to similar ones in the market, using metrics such as
price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, or enterprise value-to-EBITDA
ratio. While absolute valuation provides an intrinsic perspective, relative valuation
places the asset’s value in the context of the broader market, allowing for comparisons
and benchmarking. Both approaches contribute to a comprehensive understanding of
an investment’s potential value.
Figure 4.1: Approaches to Valuation

Valuation
Approaches

Absolute Relative
Valuation Valuation
Approach Approach

When assessing a potential investment, investors often seek comprehensive information

about the stock or opportunity. Numerous metrics are employed to gauge a company’s
financial well-being and forecast the success of an investment. The absolute valuation
formula can offer valuable insights into the future value of a stock.

4.3 INTRODUCTION TO ABSOLUTE VALUATION

Absolute valuation determines the fundamental value of an object or investment in
the absence of market influences. Absolute value highlights an asset’s distinguishing
characteristics and projected cash flow, as opposed to relative valuation, which compares
120 it to market counterparts. Earnings, dividends, and growth are used to value an investment
in this method. To evaluate a stock, discounted cash flow (DCF) analysis and dividend
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discount model (DDM) valuation employ expected future dividends. Absolute valuation NOTES
assists investors, analysts, and organizations in making educated decisions by evaluating
an asset’s fundamentals. This technique provides a more in-depth understanding of its
significance.
Absolute valuation, a systematic technique for determining the value of an asset or
investment regardless of market conditions or comparable assets, is essential for
financial and investment professionals to understand. Absolute valuation considers an
asset’s fundamental characteristics as well as its economic value. In contrast to relative
valuation, which compares an asset to its market rivals, absolute value analyses cash
flow, earnings, and growth potential. Absolute value is frequently determined through
discounted cash flow (DCF) analysis. Future financial flows are forecasted and discounted
to present value. Another strategy is the dividend discount model (DDM), which uses
future dividends to value stocks. Absolute valuation provides investors and analysts
with a thorough understanding of an asset’s essential financial characteristics, allowing
them to make informed decisions. This method is useful when market conditions do not
accurately represent the worth of an investment, highlighting the significance of unbiased
economic analysis.

4.3.1 PURPOSE AND APPLICATION

Absolute value is used by investors, analysts, and organizations to completely appraise an
item. Absolute valuation assigns a value to an item based on its intrinsic characteristics
rather than market movements or asset comparisons. Absolute valuation evaluates
investment desirability based on inherent worth. This technique assists investors in
identifying opportunities where the market price may not reflect the underlying value of
the investment, allowing for informed asset acquisition and disposal. The value of a firm or
its components is determined by absolute valuation. Knowing a target company’s genuine
value is critical in mergers and acquisitions for fair negotiations and avoiding overpaying
or underpaying. Businesses use absolute valuation methodologies to analyse the financial
feasibility of a project or investment. Predicted cash flows discounted to their current
value can assist businesses in determining the financial feasibility and strategic alignment
of a project. Absolute valuation is widely used in stock valuation. A stock is valued using
the Discounted Cash Flow (DCF) analysis and Dividend Discount Model (DDM) based
on its future cash flows or dividends. This information assists investors in making stock
purchases and sales. Absolute value discloses the economic characteristics of an asset,
simplifying risk management. It is used in investment decisions, business valuations, and
project evaluations. This strategy is useful when market conditions do not correspond to
investment value.

4.3.2 METHODS OF ABSOLUTE VALUATION

Absolute valuation is the process of determining the worth of an asset based on its
fundamentals and cash flow forecasts. The following are some fundamental absolute
valuation methods:
• Discounted Cash Flow (DCF) Analysis
The Discounted Cash Flow (DCF) approach is used to assess the worth of an asset with
the help of estimated future cash flows of an asset. It is assumed that the current
value of money surpasses its future value. A discount rate converts future cash flows 121
to present value. It’s worth is determined by the reduced future cash flows.
UNIT 4
Valuation
NOTES The Discounted Cash Flow (DCF) model employs a formula to assess a business’s rate
of return by examining expected future cash inflows and outflows. The outcome is a
forecasted cash flow, providing insights into the company’s ability to sustain growth
over a specific period.

CFn
PV0 = ∑Nn =1
(1 + rn )n
Where:
PV0 = Present value at time 0
CFn = Cash flow in period n
rn = Interest rate in period n
N = Number of periods
• Dividend Discount Model (DDM)
The primary purpose of DDM is to value stocks by projecting and evaluating future
dividends. To determine a stock’s value, the present value of all future dividend
payments is assumed. The model calculates the present value of expected future
dividends by utilizing the required rate of return as the discount rate.
The Dividend Discount Model (DDM) utilizes a straightforward mathematical
approach to estimate future dividend payments and the cost of equity share capital.
However, the valuation it produces may lack accuracy, as it relies on the assumption
that dividends equate to cash flow, which may not always hold true.

Dn
∑
N
PV0 = n =1 (1 + r )
n n

Where:
PV0 = Present value at time 0
Dn = Cash flow in period n
rn = Interest rate in period n
N = Number of periods
• Earnings Capitalization Model
Capitalization of earnings is a valuation approach that assesses the value of a company
by estimating its expected profits derived from current earnings and anticipated future
performance. This method involves calculating the net present value (NPV) of projected
future profits or cash flows and dividing it by the capitalization rate (cap rate). It is an
income-based valuation method that considers the current cash flow, the annual rate
of return, and the anticipated value of the business.
Determining a capitalization rate for a business requires in-depth research and industry
knowledge. Typically, rates for small businesses in the Indian context range from 20%
to 25%, representing the Return on Investment (ROI) that potential buyers seek when
122
considering a business acquisition.
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It’s important to note that the ROI calculation doesn’t include a salary for the new NOTES
owner. In such cases, the owner’s salary must be considered separately from the ROI
calculation. For instance, if a small business generates Rs. 50,00,000 annually and pays
the owner a Fair Market Value (FMV) salary of Rs. 20,00,000 annually, Rs. 30,00,000
would be used for valuation purposes.
Once all relevant variables are known, calculating the capitalization rate involves
a straightforward formula: operating income divided by the purchase price of the
investment or property. Determine the annual gross income of the investment, deduct
its operating expenses to find the net operating income, and then divide the net
operating income by the purchase price to arrive at the capitalization rate.
• Residual Income Valuation
Residual income valuation, also referred to as the residual income model or method, is an
equity valuation approach. It posits that the value of a company’s stock is equivalent to the
present value of future residual incomes, discounted at the relevant cost of equity.
Residual Income = Net Income – Equity Capital × Cost of Equity
Residual income valuation operates on the assumption that a company’s earnings
should reflect the true cost of capital, encompassing both the cost of debt and the cost
of equity. While net income accounting incorporates the cost of debt, it overlooks the
cost of equity, as dividends and other equity distributions are excluded from the net
income calculation.
This discrepancy means that net income does not truly represent the economic profit
of a company. Furthermore, in certain situations, reported accounting profits may not
align with economic profitability once equity costs are factored in.
Residual income, in contrast, adjusts the company’s income to account for the cost of
equity. The cost of equity represents the required rate of return demanded by investors,
compensating for opportunity cost and associated risk. Consequently, the value of a
company determined through residual income valuation is generally considered more
precise as it is grounded in the economic profits of the company.
• Asset-Based Valuation
Asset-based valuation is a technique employed to ascertain a company’s worth based
on its tangible and intangible assets. The valuation is calculated using the formula:

Total Asset Value – Total Liabilities = Net Asset Value (NAV)

This process entails identifying and appraising tangible assets (e.g., real estate, machinery)
and intangible assets (e.g., patents, trademarks) through suitable valuation methods.
By deducting the company’s liabilities from the total asset value, the resulting NAV
serves as an estimate of the company’s value grounded in its underlying assets. This
approach presupposes that the primary value of the company resides in its assets. Asset-
based valuation proves beneficial for investment analysis, mergers and acquisitions,
and overall business valuation.
While asset-based valuation is effective, especially for companies with easily valuated
assets, it has limitations. Notably, it overlooks the company’s future earnings potential
and the value of intangible assets, which can be substantial for certain businesses. 123
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Valuation
NOTES CHECK YOUR PROGRESS – I
1. What is the primary purpose of Absolute Valuation?
(a) Comparing assets in the market.
(b) Assessing cash flow and growth potential.
(c) Analysing market conditions.
(d) Evaluating liquidation value.
2. What does the Discounted Cash Flow (DCF) method consider determining the
current value of an asset?
(a) Projected future cash flows.
(b) Historical cost
(c) Net book value
(d) Liquidation value
3. In which scenario is Absolute Valuation particularly useful?
(a) When market conditions reflect intrinsic value.
(b) When comparing assets in the market.
(c) During volatile market conditions.
(d) When analysing liquidation value.
4. Absolute Valuation focuses on comparing an asset to similar assets in the market.
(a) True
(b) False
5. True or False: Absolute Valuation is particularly useful during volatile market
conditions.
(a) True
(b) False

4.4 CONCEPT OF INTRINSIC VALUE

Financial fundamentals include intrinsic value, which is the inherent value of an asset
that is unaffected by market changes or external influences. Inherent value refers to the
desirable economic characteristics that influence an asset’s value. Along with the market
price, stock earnings, growth potential, and financial stability are considered. An asset’s
intrinsic value is defined by its characteristics and future cash inflows. To evaluate a
security, investors use discounted cash flow (DCF) analysis or the dividend discount
model. To establish if a market asset is overpriced or under-priced. If an asset’s inherent
value exceeds its market price, it is undervalued and a smart investment. If the asset’s
intrinsic value is less than its market price, it may be overpriced. Understanding intrinsic
value enables investors to make decisions based on economic value rather than market
sentiment or short-term volatility.
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4.4.1 DEFINITION OF INTRINSIC VALUE NOTES
“Intrinsic value is the actual value of a company or an asset based on an underlying
perception of its true value, including all aspects of the business, in terms of both tangible
and intangible factors.” Warren Buffett, the famed investor.
“The intrinsic value of a security is the present value of its future cash flows, discounted
at an appropriate rate, considering the margin of safety to account for uncertainties.”
Benjamin Graham was a value investor pioneer.
The intrinsic worth of an asset is defined by its economic and basic characteristics, not by
its market value. It is used to evaluate investments in basic analysis.” Investopedia.
“Intrinsic value is the discounted value of all future distributions (dividends and interest)
a security will provide over its lifetime, adjusted for risk.” John Burr Williams Financial
Analyst and Economist.
The inherent worth of a company or investment is the sole way to determine its
attractiveness. It is exclusively responsible for investment success.” Berkshire Hathaway
vice chairman Charlie Munger.

4.4.2 CALCULATING INTRINSIC VALUE

Prior to making any investments, it is critical to determine the stock’s intrinsic value.
A stock’s intrinsic value reflects its true worth. There are several methods for calculating a
stock’s intrinsic value. n. By comparing a stock’s market value to its estimated intrinsic value,
an investment opportunity can be identified. People can use intrinsic and market stock
values interchangeably. Nonetheless, there are significant differences between these ideas.
The intrinsic value of a stock assists investors in determining its worth. Consider the
potential financial gain from owning a share. It is critical to consider both tangible and
intangible factors when determining the intrinsic value of a share. Using the concept of
intrinsic value, investors can determine the highest price at which to purchase a share.
The importance of intrinsic value of shares lies in its consideration of both qualitative and
quantitative factors. The determination of intrinsic value is the first step in fundamental
stock analysis. As a result, stock intrinsic value estimation is critical.
The calculation of a share’s intrinsic value establishes a market price benchmark. The intrinsic
value accurately portrays stock performance when the financial accounts have different
values. There are numerous methods for calculating stock intrinsic value. Let’s look at few
approaches for calculating stock intrinsic value.
I. Discounted Cash Flow Analysis
The intrinsic value of most stocks is estimated using discounted cash flow analysis.
Also known as DCF analysis. This method of calculating intrinsic value consists of three
easy steps:
• Calculate the company’s projected cash flow before investing in its stock.
• Calculate the present value of all predicted future cash flows.
• Add all present values to determine the share’s intrinsic value.
It is difficult to forecast a company’s cash flow. To forecast cash flows, the financial
accounts of the organization must be studied. To understand corporate advancement, 125
you must read news and editorials.
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NOTES The formula used in this method of calculating the intrinsic value of the share is:
Intrinsic value

CF1 CF2 CF3 CFn

+ + +…+
(1 + r )1
(1 + r )2
(1 + r ) 3
( 1 + r )n
Here,    
CF shows the cash flow, where CF1 is the cash flow of the 1st year, and so on.
‘r’ is the rate of return based on the existing market standards.
II. Analysis Based on a Financial Metric
To value shares, financial metric analysis is used. Price-to-earnings ratios of an industry
can be used to calculate stock value. This measure requires P/E ratio data.
The intrinsic value of a share is calculated using the following formula:

Intrinsic value = Earnings per share (EPS) × (1 + r) × P/E ratio

Here, r stands for the expected long term growth rate of the earnings.
III. Asset-Based Valuation
Asset-based valuation can be used to calculate a share’s intrinsic value. This method
appeals to new investors because it avoids the need for complicated cash flow calculations.
This procedure’s mathematical formula is:
Intrinsic value = (Sum of a company’s assets, both tangible and intangible)
– (Sum of a company’s liabilities)
This approach disregards the company’s development and expansion opportunities.
As a result, using this method to calculate intrinsic value may not allow for meaningful
comparisons or accurately reflect share value.
IV. Dividend Discount Models
Analysts frequently use the dividend discount model (DDM) to calculate the intrinsic value
of stocks. The model discounts the expected future dividends to assess the value of a
stock. Based on future earning’s growth expectations, the model has variants like constant
growth model, two stage growth model, H model. DDM in detail shall be discussed in
subsequent units.
The formula used to calculate the intrinsic value of a mature firm expected to grow at a
constant rate is:

P = D1/(r - g)
Here,
P is the stock’s present value,
D1 = dividend of one year,
r = required rate of return for the equity and
g = annual growth rate of dividends in perpetuity.
126
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V. Residual Income Models NOTES
You can also use the residual income models to calculate the value of the shares.
The formula that can help you calculate the value of the share is:

RIt
V0 = BV0 + ∑ (1 + r ) t

Here,
BV0 is the existing book value of the company’s shares
RIt is the residual income of the company for a particular period. Residual Income, in the
context of valuation, refers to Net Income less opportunity cost of all sources of capital,
it is a measure of economic profit.
And r is the cost of equity.
Here, the formula uses the difference between the EPS and the book value of the share to
calculate the intrinsic value of the share.
The intrinsic value of a stock helps to understand its financial gains. It denotes the true
value of a share. The various applications of intrinsic value estimation must be understood
by active investors. Depending on the values available, any of the methods can be used.
When evaluating stock performance, it is critical to distinguish between market value and
intrinsic value.

4.5 INTRODUCTION TO RELATIVE VALUATION

After getting a comprehensive understanding about absolute valuation, we now will talk
about relative valuation.
To appraise an asset, relative valuation employs comparable asset market prices.
The attractiveness of an investment is determined by the market value of comparable
assets. Market efficiency requires that assets with equivalent features in the same market
have similar relative value prices. Absolute valuation looks at the fundamentals of an
asset to determine its worth.
Comparing financial metrics and ratios results in relative valuation. Popular finance
ratios include P/E, P/B, and enterprise value-to-EBITDA. The price-to-earnings (P/E) ratio
estimates a company’s market value by comparing its stock price to its earnings per share.
The market analyses a company’s market value to its book value to establish its net asset
value, like the P/B ratio.
Equity analysts frequently compare the value multiples of a target firm to those of its
industry peers or the market. Comparative analysis may uncover stocks that are overvalued
or under-priced. Investors seek out low-cost companies with lower value multiples than
comparable organisations, indicating stock price rise.

4.5.1 COMPARATIVE ANALYSIS IN RELATIVE VALUATION

Comparative analysis is required for relative value, which compares one asset to similar
ones. In relative valuation, comparative analysis compares a target asset’s financial metrics
and ratios to similar assets or industry standards. The goal is to evaluate the valuation of
127
the target asset to peers, industry benchmarks, or market indices.
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NOTES Key elements of comparative analysis in relative valuation include:
1. Valuation Multiples
In financial analysis, valuation multiples, such as Price-to-Earnings (P/E),
Price-to-Book (P/B), or enterprise value-to-EBITDA, are frequently employed
for comparisons between different companies or industries. These multiples
provide a relative measure of a company’s valuation by comparing its financial
metrics to similar metrics of other entities. For instance, P/E ratio compares a
company’s stock price to its earnings per share, helping investors assess how the
market values its earnings.
Asset valuation standards play a crucial role in ensuring consistency when
determining these multiples. These standards provide guidelines and principles
for evaluating the worth of a company’s assets, ensuring a uniform approach
across various analyses. Consistent application of valuation multiples, guided by
established asset valuation standards, facilitates a more accurate and reliable
assessment of a company’s financial standing in relation to its peers or industry
benchmarks.
2. Peer Group Comparison
Analysts form peer groups of companies in the same industry or with similar
business models. The target asset’s financial metrics are compared to the
average or median of its peers.
3. Benchmarking Against Market Indices
A type of comparative analysis is comparing performance to market indices.
Compare a stock’s price-to-earnings (P/E) ratio to the average P/E ratio of a
market index to determine its valuation.
4. Identifying Outliers
Outliers in a peer group are identified through comparative analysis as assets that
deviate significantly from the norm. Outliers can indicate unusual characteristics
or factors that influence asset valuation.
5. Industry Standards
Understanding industry-specific variables is required for comparative analysis.
Industry valuation multiples can vary depending on factors such as growth, risk,
and capital intensity.
6. Relative Strengths and Weaknesses
Investors and analysts can evaluate the target asset’s advantages and
disadvantages by conducting a comparative analysis with its counterparts. It aids
in identifying valuation disparities.
7. Investment Decision-Making
Comparative analysis informs investment decisions. If the valuation multiples of
a target asset are lower than those of its peers, but the company has comparable
growth prospects and risk profile, the asset may be considered undervalued.
8. Dynamic Analysis Over Time
Dynamic comparison analysis must be performed on a frequent basis. Market,
industry, and company performance can all have an impact on valuation.
128 Although comparative analysis has limits, it is useful. Comparable organizations’
auditing, growth, and risk characteristics can all have an impact on comparisons.
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To conduct an effective comparative analysis in relative value, one must NOTES
understand industry subtleties and carefully examine crucial aspects.

4.5.2 KEY METRICS IN RELATIVE VALUATION

Financial ratios and multiples assist analysts in determining the worth of a target asset in
relation to its peers or the market. These indicators compare the asset’s market value to
the market value of its peers. The following valuation indicators are comparable:
• Price-to-Earnings (P/E) Ratio
The price-to-earnings (P/E) ratio compares a company’s stock price to its earnings per share
(EPS). Because investors are willing to pay more per unit of profits, a company with a high
P/E ratio may be overpriced. A company with a low P/E ratio may be undervalued.
• Price-to-Book (P/B) Ratio
The Price-to-Book (P/B) Ratio reflects the correlation between an organization’s total
market value, represented by its outstanding shares, and the book value of its equity.
Essentially, it establishes a link between the market capitalization and the intrinsic
value of assets held by the organization.
In some instances, these components are condensed to a per-share basis. Here, the
total market value of outstanding shares is divided by the number of shares, and
similarly, the net value of an organization’s assets is divided by the number of shares
actively traded in the market.
Value investors, seeking stocks trading below their intrinsic value, often utilize the P/B
ratio among other metrics. This ratio serves as a pivotal tool for value investors to
evaluate whether a company’s stocks are overvalued or undervalued. The P/B value
emerges as a crucial factor in the context of value investing, guiding investors in
identifying stocks that align with their strategy of investing in undervalued assets.
• Enterprise Value-to-EBITDA (EV/EBITDA) Ratio
The enterprise multiple, or EV multiple, is a ratio employed for company valuation.
Calculated by dividing enterprise value by earnings before interest, taxes, depreciation,
and amortization (EBITDA), this metric assesses a company from the perspective of a
potential acquirer, considering the company’s debt.
• Dividend Yield
The annual dividend payment of a stock expressed as a percentage of its stock price is
referred to as dividend yield. A higher dividend yield may indicate an undervalued stock
because it indicates that investors are earning a higher return than the stock’s price.
• Price-to-Sales (P/S) Ratio
The P/S ratio is used to compare the market capitalization and revenue of a company.
A lower price-to-sales (P/S) ratio may indicate undervaluation because investors are
paying less per unit of sales.
• Comparative Revenue Growth
Assessing a specific asset’s revenue growth by comparing it to the growth rates of
similar assets or the industry’s average growth rate. Comparable revenue growth may 129
justify a higher valuation, whereas slower growth may justify a lower valuation.
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NOTES • Earnings Growth Rate
Considering the potential increase in a company’s future profits. An increase in the
expected rate of earnings growth can boost the valuation, while a decrease in the rate
can lower it.
• Price/Earnings-to-Growth (PEG) Ratio
The PEG ratio compares the price-to-earnings (P/E) ratio to the expected earnings
growth rate. A stock with a PEG ratio less than one may be undervalued because the
market has not adequately factored in the expected increase in earnings.
These metrics help analysts and investors evaluate an asset’s relative appeal in
comparison to similar assets, allowing them to make well-informed investment
decisions based on the market’s perception of value.

CHECK YOUR PROGRESS – II

1. What is the primary focus of absolute valuation?
(a) Market influences
(b) Intrinsic qualities and cash flow
(c) Relative market comparisons
(d) Industry dynamics
2. Which method of absolute valuation is commonly used to determine the intrinsic
value of stocks by considering future cash flows?
(a) Comparable Company Analysis (CCA)
(b) Dividend Discount Model (DDM)
(c) Discounted Cash Flow (DCF) Analysis
(d) Earnings Capitalization Model
3. What is the significance of intrinsic value in investment analysis?
(a) It determines short-term market sentiment.
(b) It guides long-term planning and mitigates market volatility.
(c) It focuses on market comparisons for decision-making.
(d) It measures industry-specific variables.
4. Absolute valuation focuses on determining an asset’s intrinsic worth regardless of
market influences.
(a) True
(b) False
5. Comparative analysis in relative valuation involves comparing a target asset’s
financial metrics to those of dissimilar assets.
(a) True
130 (b) False
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4.6 REPLACEMENT COST METHOD OF VALUATION NOTES
The Replacement Cost Method calculates the cost of replacing an item with a comparable
item at current market prices. This method is used to determine the worth of buildings,
machinery, and infrastructure. In today’s market, asset valuation is intimately related to
duplicate or substitute costs. The Replacement Cost Method is useful for uncommon or
specialist assets whose market value may not accurately reflect their true worth. It assists
investors, insurers, and industry leaders in estimating the costs of asset replication.

4.6.1 UNDERSTANDING REPLACEMENT COST

Replacement cost awareness is required for asset appraisal, insurance, and management.
The replacement cost is the cost of purchasing or manufacturing an asset at current
market pricing. This concept has an impact on buildings, machines, and infrastructure.

KEY POINTS IN UNDERSTANDING REPLACEMENT COST

• Asset Reproduction
Replacement cost methodology goes beyond merely assessing the purchase price
of an item. It focuses on the cost involved in reproducing or acquiring a new asset,
considering factors such as construction, production, or procurement. This approach
provides a more comprehensive evaluation by accounting for the expenses associated
with replicating the functionality or characteristics of the existing asset, ensuring a
realistic estimate of its value.
• Market Conditions
It considers market conditions, labour, material, and replacement costs.
• Insurance Valuation
The insurance coverage required is determined by the replacement cost of a damaged
or destroyed asset. This assures that the policyholder receives a fair return for asset
reconstruction or substitution at market rates.
• Unique and Specialized Assets
Replacement cost benefits assets that are unique, specialist, or undervalued. This is
common in the specialized equipment and facility market.
• Depreciation Considerations
In contrast to market value, replacement cost takes depreciation into account. It is the
cost of replacing an asset, regardless of its age or condition.
• Decision-Making Tool
Understanding the concept of replacement cost is useful for industry decision-makers.
It is useful for making strategic investment, maintenance, and insurance decisions
because it discloses the financial costs of maintaining or replacing assets.
• Risk Management
Businesses and investors use replacement cost to reduce risk. Evaluating the costs of
replacing assets aids in planning and allocating resources for unforeseen events such
as accidents, natural disasters, and technological obsolescence. 131
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NOTES • Economic Changes
Replacement cost considers the impact of economic fluctuations on expenses related
to materials, labour, and other reproduction costs.
Understanding the concept of replacement cost is critical for precise assessment, risk
reduction, and making informed decisions in specific industries. Insurance coverage,
asset management, and strategic planning all depend on the cost of replacement.
It includes the financial implications of either maintaining or replacing assets in an
ever-changing economy.

4.6.2 CHALLENGES AND CONSIDERATIONS

When investigating financial evaluation, it is critical to recognise the difficulties and factors
to be considered when employing the Replacement Cost Method. These will follow.
• Dynamic Cost Fluctuations
Cost fluctuations are a major source of concern. Fluctuations in the prices of materials,
labour, and technology can have an impact on replacement cost estimates. To ensure
method precision, these fluctuations must be closely monitored.
• Subjectivity in Valuation
Asset valuation based on replacement cost is subjective, especially when estimating
the asset’s economic lifespan. Predicting the useful life of an asset requires foresight,
which can affect its valuation.
• Intangible Assets
When using the Replacement Cost Method, it is difficult to value intangible assets such
as brand reputation and intellectual property. It is difficult to assign a replacement cost
to intangible assets that lack physical presence, necessitating the use of alternative
valuation methods.
• Quality of Reproduction
Duplicating an asset does not guarantee the same quality or efficiency. Because
of technological advancements, the new asset may be more advanced than its
predecessor, making determining their equivalence difficult.
• Market Perception
Investors and stakeholders may place varying weights on replacement cost versus
market value. The concept of replacement cost focuses on the cost of rebuilding an
asset, whereas market value considers factors such as demand, supply, and sentiment,
all of which can affect the asset’s value.
• Inflation Impact
Inflation influences the Replacement Cost Method. Failure to account for inflation
rates accurately can result in an estimated replacement cost that does not accurately
reflect the economic situation, affecting reliability.
• Data Availability and Accuracy
The method relies on the availability and accuracy of both current and historical data.
132 The value of research is derived from its ability to prevent the use of incomplete or
inaccurate data, which can have a negative impact on replacement cost estimates.
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Addressing these issues effectively necessitates a delicate balance of theoretical NOTES
knowledge and practical application. When used with caution and mindfulness,
the Replacement Cost Method can help investors and decision-makers navigate the
complex landscape of financial valuation.

CHECK YOUR PROGRESS – III

1. What does the Replacement Cost Method primarily estimate?
(a) Cost of replacing an asset at current market prices
(b) Historical cost of an asset
(c) Market value of an asset
(d) Depreciation value of an asset
2. Why is the Replacement Cost Method particularly useful for unique or specialized
assets?
(a) It considers market fluctuations.
(b) It focuses on historical costs.
(c) Market value accurately reflects their true worth.
(d) Their market value may not accurately reflect their true worth.
3. What is a key consideration when using the Replacement Cost Method for insurance
valuation?
(a) Market conditions
(b) Depreciation
(c) Predicting the asset’s economic lifespan.
(d) Ensuring insurance coverage corresponds to reconstruction costs.
4. The Replacement Cost Method is particularly beneficial for assets with accurately
reflected market values.
(a) True
(b) False
5. Replacement cost estimates are not affected by dynamic fluctuations in material
and labour prices.
(a) True
(b) False

4.7 LIQUIDATION VALUE

The liquidation value of a company is the theoretical sum obtained by selling its
assets and paying off its debts. This valuation method assumes that the company is
in financial trouble and needs to sell its assets quickly, often at a loss. The goal is to
determine the remaining value for shareholders after all debts and obligations have
been satisfied. 133
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NOTES Sum of the Parts Valuation
Sum of the Parts (SOTP) Valuation is a financial valuation method that involves assessing
the individual components or segments of a company to determine its overall value.
Instead of valuing the entire business as a single entity, SOTP breaks down the company
into distinct parts or business units, assigning a separate valuation to each. This approach
is particularly useful when a company operates diverse and independent business
segments, each with its own financial dynamics.
The first step in Sum of the Parts Valuation is to identify and segregate the various business
units or assets within the company. These components can include subsidiaries, divisions,
or any significant holdings. Once the individual parts are identified, each segment is
valued independently using appropriate valuation methods such as discounted cash flow
(DCF), comparable company analysis (CCA), or precedent transactions. These valuation
methods help determine the fair value of each segment based on its specific financials,
growth prospects, and market conditions.
After valuing each part separately, the final step is to sum up these individual valuations
to arrive at the total estimated value of the entire company. This comprehensive approach
allows investors, analysts, or stakeholders to gain insights into the intrinsic value of each
business unit, aiding in strategic decision-making, potential divestitures, or mergers and
acquisitions. Sum of the Parts Valuation provides a nuanced perspective, acknowledging
the diversity of a company’s operations and ensuring a more accurate reflection of its
overall worth.

4.7.1 CALCULATION OF LIQUIDATION VALUE

To establish liquidation value, a company’s assets, obligations, and sale proceeds must be
analysed. There are two basic approaches for calculating liquidation value:
Figure 4.2: Basic Approaches for Calculating Liquidation Value

Orderly Liquidaon Value (OLV):

• This strategy indicates asset disposal that is systema c and non-disrup ve. It iden fies
the ideal me to sell to maximize asset value. Obliga ons are deducted from the fair
market value of each asset. Fire sales are less accurate than orderly liquida on values.

Forced Liquidaon Value (FLV):

• The forced liquida on value of assets is their es mated value when quickly and cheaply
liquidated. This cau ous approach addresses a me-sensi ve situa on in which assets
must be converted into cash rapidly. The evalua on considers quick sales, buyer
discounts, and liability.

4.7.2 KEY COMPONENTS

• Assets
The liquidation value of a company is heavily influenced by the valuation of its assets.
Real estate, equipment, inventory, and intangible assets such as patents and trademarks
134
are examples of assets. The value of distressed sales is determined by current market
conditions and estimated asset values.
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• Liabilities NOTES
The calculation of liquidation value must include all outstanding debts, obligations,
and liabilities. The company is required to pay secured and unsecured debts, cover
operational expenses, and meet other financial obligations. Deduct liabilities from
assets to arrive at the liquidation value.

4.7.3 SIGNIFICANCE AND USE CASES

• Financial Distress
In times of financial distress, bankruptcy, or insolvency, the importance of liquidation
value is magnified. In a compelled sale, this shows the amount that creditors can
recover and the remaining value for equity holders.
• Investment Decision-Making:
The liquidation value is just one of several factors to consider when evaluating
financially troubled companies for potential investment. Understanding the liquidation
recovery process aids in determining the level of investment risk and potential gain.
• Loan Collateral
When making loans to businesses, lenders may use the liquidation value as collateral.
Understanding the asset-backed value in the event of default, reduces risk.
• Mergers and Acquisitions
When acquiring firms consider a target’s liquidation value, they are assessing its lowest
possible worth in M&A transactions. This type of information has the potential to
influence negotiations.

4.7.4 LIMITATIONS
• Market Conditions
Market conditions have a significant impact on liquidation value calculations. In volatile
markets, an influx of comparable assets can reduce their value.
• Asset Depreciation
The assumption behind asset valuation is that they can be sold at their appraised
values. The current market conditions, as well as the effects of wear and depreciation,
can reduce the value of assets during a forced transaction.
• Intangible Assets
Intangible assets may have limited marketability in a distressed sale, making
determining their liquidation value more difficult. Such assets may be in short supply.
The liquidation value is critical in determining a company’s worth when it is in
financial distress. While it can provide insight into possible recovery, investors and
stakeholders must consider market dynamics as well as the specifics of the distressed
situation.

4.8 FACTORS AFFECTING VALUATION

The process of determining the economic worth of a company, asset, or investment is
referred to as valuation. It is required for mergers and acquisitions, as well as fundraising 135
and investment decisions. Valuation is a complicated process because many factors
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NOTES influence an entity’s perceived worth. These factors must be understood by investors,
analysts, and businesspeople involved in financial decision-making. In this section, we
examine the factors that influence the valuation.
• Revenue and Profitability
The financial performance of a manufacturing company, including its revenue and
profitability trends, is a critical factor in valuation. Consistent and growing revenues,
along with healthy profit margins, generally contribute positively to the company’s
overall value.
• Operational Efficiency
Efficiency in manufacturing processes, supply chain management, and production
capabilities can impact valuation. A well-organized and streamlined operation is
likely to be viewed more favourably, as it can contribute to cost savings and higher
profitability.
• Asset Base
The value of physical assets, such as machinery, equipment, and facilities, plays a
significant role. The condition, age, and technological relevance of these assets are
considered in determining their contribution to the overall valuation.
• Market Position and Competition
The manufacturing industry’s competitive landscape and the company’s market
position are crucial. A leading position in the market, strong brand recognition, and
competitive advantages can positively influence valuation.
• Industry Trends and Demand
The manufacturing industry is often sensitive to economic cycles and industry trends.
A company operating in a growing or high-demand sector is likely to be valued higher
than one facing challenges or declining demand.
• Technology and Innovation
Manufacturing companies embracing technological advancements and innovation
are often viewed more favourably. Investments in research and development,
automation, and the adoption of modern technologies can positively impact
valuation.
• Customer Base and Diversification
A diverse and stable customer base is considered an asset. Dependence on a few
customers or industries may pose risks, and valuations may reflect the level of
diversification and customer stability.
• Regulatory Compliance
Adherence to industry regulations and environmental standards is crucial. Non-compliance
issues can negatively impact a company’s valuation and raise concerns among potential
investors.
• Management Team
The competence and experience of the management team are key considerations.
A strong leadership team with a track record of effective decision-making and strategic
136 planning can positively influence the valuation.
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• Future Growth Prospects NOTES
Forecasts for future growth and expansion plans contribute to the valuation. Companies
with clear strategies for adapting to market changes and capturing new opportunities
are often assigned higher valuations.
• Regulatory Environment
Regulatory factors, particularly in regulated industries, can have a significant impact on
business valuation. Regulations, compliance costs, and potential legal liabilities can all
have an impact on a company’s financial performance and worth.
• Macroeconomic Factors
Macroeconomic factors such as interest rates, inflation, and currency exchange rates
all have an impact on a company’s financial state. These variables influence the costs
of capital, the interest rates used to calculate the present value of future cash flows,
and the overall desirability of an investment, all of which influence the determination
of an asset’s value.
• Technological Disruption
The rapid evolution of technology can have a significant impact on valuing industries
that undergo frequent and significant changes. Companies that are technologically
advanced may have a higher value than those that are obsolete.
• Capital Structure and Debt Levels
A company’s valuation is influenced by its capital structure, which includes the
debt-equity ratio. High levels of debt can exacerbate financial vulnerability and reduce
a company’s valuation. Investors evaluate the financial stability of a company by
comparing its equity and debt.
Several factors influence valuation, making it challenging. To properly value a firm or
investment, investors and analysts must consider these factors. Understanding the
relationships between financial performance, market conditions, risk concerns, and other
variables aids stakeholders in making complex valuation decisions.

4.9 CHALLENGES TO VALUATION

Valuation is complicated and must be addressed while making financial decisions. Value
is subjective, which creates issues. Value inconsistencies can occur due to differences in
methodologies, assumptions, and discount rates. Ambiguity and value discrepancies are
caused by subjectivity. Markets and sectors that are constantly changing complicate problems.
The future of a corporation is determined by economic, legislative, and technological changes.
Because the corporate environment is uncertain and complicated, forecasting these changes
is difficult, and valuation methodologies may struggle to capture them.
When dealing with intangible assets, traditional valuation techniques run into difficulties.
Intellectual property, brand equity, and human capital have significant value in today’s
knowledge-based economy, but quantifying their worth is difficult. Valuation models that
rely heavily on past financial metrics may overlook or undervalue these intangibles, resulting
in an inaccurate assessment of a company’s value. Market sentiment and behaviour
complicate valuation. Investor emotions, perceptions, and short-term market dynamics can
all have an impact on stock prices, which goes beyond the scope of fundamental analysis.
Analysts attempting to make a logical assessment run into market irrationality, which refers 137
to the difference between the inherent value and the market price.
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NOTES Asymmetric information makes it difficult to accurately value a company. The presence
of information asymmetry between buyers and sellers makes it difficult to accurately
assess a company’s financial health and prospects. To address these issues, valuation
professionals must consider historical financial data, future growth prospects, industry
trends, and the overall economic context. Identifying and overcoming these challenges
improves the process of determining value and provides useful insights for making
investment and financial decisions.

CHECK YOUR PROGRESS – IV

1. What is the primary goal of determining the liquidation value of a company?
(a) Maximize profits for shareholders.
(b) Assess financial health for investment.
(c) Determine remaining value for shareholders after settling debts.
(d) Estimate market value for acquisition.
2. What is the key difference between Orderly Liquidation Value (OLV) and Forced
Liquidation Value (FLV)?
(a) OLV considers quick sales and buyer discounts.
(b) FLV assumes systematic and non-disruptive asset disposal.
(c) FLV involves liabilities subtraction from asset fair market value.
(d) OLV maximizes asset value over an appropriate time.
3. Why is the liquidation value crucial in mergers and acquisitions (M&A) transactions?
(a) It determines market conditions.
(b) It influences negotiations by assessing the lowest possible worth.
(c) It considers financial distress and bankruptcy.
(d) It focuses on industry trends.
4. Liquidation value is irrelevant in times of financial distress, bankruptcy, or insolvency.
(a) True
(b) False
5. Asymmetric information between buyers and sellers can enhance the accuracy of a
company’s valuation.
(a) True
(b) False

CASE STUDY ON VALUATION

In the face of rapid market changes and industry dynamics, Vaishali Technologies, a
prominent software development company, came to a critical decision point in evaluating
its business worth. Due to the complex nature of its intangible assets, the unpredictable
138 fluctuations in the market, and the evolving competitive environment, the company had
difficulty determining its own value.
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Vaishali Technologies’ proprietary algorithms and software allowed it to compete NOTES
effectively. Conventional valuation techniques were unable to assess the intricate
impact of intellectual assets on the company’s competitive advantage, posing valuation
challenges. The valuation team had difficulty quantifying the impact of intangibles on the
company’s value.
The software industry’s volatility reduced Vaishali’s value. Stock price volatility
because of market sentiment and short-term factors makes valuation difficult. Analysts
examined investor mood, external market conditions, and firm performance. Vaishali
Technologies operated efficiently. Experts in valuation had to investigate how new
legislation and technologies affected corporate earnings. Accurate forecasting was
required for a thorough assessment. The appraisal team was beset by information
asymmetry. Due diligence was challenging due to a lack of clear and accessible
information, particularly about competitors’ strategic activities and possibility for
collaboration. Due to a lack of data, a full industry analysis and business ecosystem
evaluation were required. A volatile market makes valuing a company like Vaishali
Technologies difficult. The valuation team conducted a thorough assessment using
their financial skills, industry knowledge, and proactive approach. The team thoroughly
evaluated Vaishali Technologies by considering intangible assets, market volatility,
regulatory changes, and information shortages.
Questions
1. How did Vaishali Technologies gain a competitive advantage through the
deployment of proprietary algorithms and software?
2. Why did earlier valuation approaches struggle to assess its impact?
3. How did market sentiment and short-term considerations affect the computer
software valuation of Vaishali Technologies?

4.10 LET US SUM UP

• Valuation is used in finance to determine the worth of assets and businesses.
• Absolute valuation assesses an asset based on its cash flows and growth prospects.
• In relative valuation, price-to-earnings ratios are used to compare assets to market
peers.
• The Replacement Cost Method assigns a monetary value to assets based on their
replacement or reproduction costs.
• Liquidation Value is an estimate of an asset’s worth if it could be sold swiftly and
cheaply.
• Market dynamics, economic developments, and industry performance all have an
impact on valuation. Because of the prevalence of uncertainty, subjective assessments,
and the volatility of financial markets, valuation is complicated.
• Because financial variables are intricate and linked, they demand a thorough study
that considers both quantitative and qualitative considerations.
• Valuation techniques include absolute, relative, intrinsic, replacement, and liquidation
approaches.
• Components Understanding is aided by a thorough study and comprehension of the
components that contribute to value and awareness.
139
• A fair and well-informed process is required to appraise the value of assets and
enterprises in various financial scenarios.
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NOTES 4.11 KEYWORDS
Valuation: The process of estimating the value of an item, business, or investment by
weighing numerous methodologies and factors.
Intrinsic Value: Investment decisions are influenced by an asset’s underlying value, which
is determined through fundamental study.
Relative Valuation: Determining the worth of assets by comparing them to similar assets
in the market using criteria such as price-to-earnings ratios.
Decision-Making: When deciding between possibilities, valuation is critical for making
educated decisions.
Absolute Valuation: Rather than relying on market conditions, the valuation approach
determines an asset’s inherent value by examining its essential attributes.
Replacement Cost Method: This valuation method considers the cost of replacing or
recreating an object, providing a different viewpoint on its value.
Liquidation Value: The anticipated value of assets that will be promptly sold, sometimes
at a discount, in emergency situations.
Comparative Analysis: A critical part of relative valuation is performing a comparison
examination of an item with similar assets in the market.
Key Metrics: In appraisal, quantitative tools are used to examine the financial well-being
and efficacy of an asset in comparison to others.

4.12 REFERENCES AND SUGGESTED ADDITIONAL READING

REFERENCES
1. Hitchner, J. R. (2017). Financial Valuation: Applications and Models. Wiley.
2. McKinsey & Company Inc. (2020). Valuation: Measuring and Managing the Value of
Companies. Wiley.
3. Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining
the Value of Any Asset. Wiley.
4. Palepu, K. G., Healy, P. M., & Peek, E. (2012). Business Analysis and Valuation: Using
Financial Statements. Cengage Learning.
5. Pignataro, P. (2013). Financial Modelling and Valuation: A Practical Guide to
Investment Banking and Private Equity. Wiley.

SUGGESTED ADDITIONAL READING

1. Damodaran, A. (2011). The Little Book of Valuation: How to Value a Company, Pick
a Stock, and Profit. Wiley.
2. Bierman, D. M. (2014). Business and Financial Analysis: Valuation, Ratio Analysis,
and Decision Analysis. Cambridge University Press.
3. Petitt, B. S., & Ferris, K. R. (2015). Valuation for Mergers and Acquisitions. Wiley.
140
4. Pinto, J. E., Henry, E., Robinson, T. R., & Stowe, J. D. (2015). Equity Asset Valuation. Wiley.
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5. Mercer, Z. C. (2006). Business Valuation: An Integrated Theory. John Wiley & Sons. NOTES
6. Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and Managing
the Value of Companies (Vol. 499). John Wiley and Sons.

4.13 SELF-ASSESSMENT QUESTIONS

1. Which method of Absolute Valuation involves forecasting future cash flows and
discounting them to present value?
(a) Discounted Cash Flow (DCF) Analysis
(b) Earnings Capitalization Model
(c) Dividend Discount Model (DDM)
(d) Asset-Based Valuation
2. What is the primary application of Absolute Valuation in mergers and acquisitions?
(a) Assessing market conditions.
(b) Determining liquidation value.
(c) Negotiating fair purchase prices.
(d) Analysing financial statements.
3. Which of the following is NOT a fundamental method of Absolute Valuation?
(a) Dividend Discount Model (DDM)
(b) Residual Income Valuation
(c) Comparable Company Analysis (CCA)
(d) Relative Valuation
4. What is the primary objective of the Dividend Discount Model (DDM) in Absolute
Valuation?
(a) Calculating residual income.
(b) Determining liquidation value.
(c) Assessing the intrinsic value of stocks.
(d) Analysing market conditions
5. What is the primary goal of Asset-Based Valuation in Absolute Valuation?
(a) Assessing cash flow.
(b) Determining liquidation value.
(c) Forecasting future earnings
(d) Comparing financial indicators.
6. Which financial metric is used in relative valuation to compare a company’s stock
price to its earnings per share (EPS)?
(a) Price-to-Book (P/B) Ratio 141
(b) Enterprise Value-to-EBITDA (EV/EBITDA) Ratio
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NOTES (c) Dividend Yield
(d) Price-to-Earnings (P/E) Ratio
7. What does the Residual Income Valuation method consider in determining the
value of an asset?
(a) Excess income over expected return
(b) Future cash flows
(c) Projected earnings
(d) Net book value
8. How does the Replacement Cost Method contribute to risk reduction in investment?
(a) By considering market perceptions.
(b) By factoring in inflation impact
(c) By providing a consistent assessment unaffected by market fluctuations.
(d) By valuing intangible assets accurately.
9. In which industry is the Replacement Cost Method especially useful due to property
values often exceeding market prices?
(a) Technology
(b) Healthcare
(c) Real estate
(d) Manufacturing
10. How do financial metrics such as P/E ratios and EBITDA multiples influence the
valuation process?
(a) They compare valuation to earnings or cash flow.
(b) They evaluate industry trends.
(c) They determine market capitalization.
(d) They assess liquidation value.

4.14 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. B. Assessing cash flow and growth potential
2. A. Projected future cash flows
3. C. During volatile market conditions
4. False
5. True
Check Your Progress – II
142 1. B. Intrinsic qualities and cash flow
2. C. Discounted Cash Flow (DCF) Analysis
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3. B. It guides long-term planning and mitigates market volatility. NOTES
4. True
5. False
Check Your Progress – III
1. A. Cost of replacing an asset at current market prices
2. D. Their market value may not accurately reflect their true worth.
3. D. Ensuring insurance coverage corresponds to reconstruction costs
4. False
5. False
Check Your Progress – IV
1. C. Determine remaining value for shareholders after settling debts
2. D. OLV maximizes asset value over an appropriate time.
3. B. It influences negotiations by assessing the lowest possible worth.
4. False
5. False

4.15 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (a) 2. (c) 3. (d) 4. (c) 5. (b)
6. (d) 7. (a) 8. (c) 9. (c) 10. (a)

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 UNIT 5
ECONOMIC ANALYSIS

STRUCTURE
5.0 Objectives
5.1 Introduction
5.2 Economic Indicators
5.3 Leading, Lagging and Coincident Indicators
5.4 Forecasting Economic Outlook
5.5 Let Us Sum Up
5.6 Keywords
5.7 Self-Assessment Questions
5.8 References and Suggested Additional Readings
5.9 Check Your Progress – Possible Answers
5.10 Answers to Self-Assessment Questions

5.0 OBJECTIVES
After reading this unit, you will be able to:
1. develop an understanding of Fundamental analysis and analyze the concept of
Economy-Industry-Company framework.
2. understand the significance of economic analysis for equity investment decisions.
3. discuss the importance of such analysis and its role in investment decisions.
4. understand short term econometric forecasting techniques to forecast economy.

RECAP OF UNIT 4
In the previous chapter, we explored the concept of valuation and its significance in financial
management. We also delved into the fundamental principles of valuation, including
the various approaches and methodologies used to determine the value of an asset or
company. This included both absolute and relative valuation techniques. The chapter
emphasized on absolute valuation involves assessing the intrinsic value of an asset or
company based on its fundamental characteristics, such as cash flows, growth prospects,
and risk factors. We also discussed different absolute valuation models, such as discounted
cash flow (DCF) analysis and earnings-based models. We also explored intrinsic value that
represents the true worth of an asset or company based on its underlying fundamentals. 145
We also studied the concept of intrinsic value and its importance in making investment
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NOTES decisions. We also discussed the popular relative valuation methods, including price-to-
earnings (P/E) ratio, price-to-sales (P/S) ratio, and enterprise value-to-EBITDA (EV/EBITDA)
ratio. We also learned the replacement cost method of valuation involves determining
the value of an asset or company based on the cost of replacing it with a similar asset
or company.

5.1 INTRODUCTION
The current unit deals with Fundamental analysis which is a valuation tool used by
analysts to determine if a stock is over or under valued. This is one of the most popular
methods used by investing professionals. Fundamental Analysis measures a security’s
intrinsic value by examining the economy, industry and company. As discussed in
the previous unit, the intrinsic value is the true worth of any investment or security
determined through fundamental research i.e. by understanding the economic and
market conditions. It is the “fair value” of any security which the investors believe the
security should be trading at and then on the basis of the fair or anticipated value, the
investor compares it with the market value and takes a decision whether to invest or
forego it.
Well, thought out and measured decisions helps investors in getting better returns.
It is essential in achieving success in the financial markets. The analysis of the macro
environment is essential in understanding stock prices. There is no reason to invest in
risky assets if the economy is not expected to be good. For instance, an increase in interest
rates in the economy makes borrowing costlier. In that case, the investors may not prefer
companies with a significant portion of debt for investment. The financial risk of such
companies increases and this could negatively impact the stock prices of such companies.
On the other hand, companies with lower debt in the capital structure may witness a
positive growth in the prices of their stocks.
Similarly, geopolitical developments or incidents like war, ethnic strife or even natural
disasters impact share prices. All these developments drive investor sentiments. It is the
favourable geopolitical events that leads to increase in prices while adverse events can
pull the prices downward.
In this unit, we will discuss on techniques of evaluating future economic performance.

5.1.1 FUNDAMENTAL ANALYSIS

There are two broad approaches for evaluating investment decisions. These are
i) Fundamental Analysis and ii) Technical Analysis. In the first approach, the intrinsic value
or true value of a security is analyzed on the basis of earnings of the company, growth
rate and risk exposure of the company which in turn depends upon several macroeconomic
and microeconomic factors. The second approach concentrates on forecasting a security’s
price movements.
The fundamental analysis consists of three main parts:
(a) Economic Analysis
(b) Industry Analysis
(c) Company Analysis
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Fundamental Analysis starts with understanding the economic outlook. Broad macro­ NOTES
economic indicators are studied. This is followed by identifying industries which are
poised to grow and finally selecting companies or stock from the selected industries. The
Economy-Industry-Company (EIC) Framework thus forms the basis of conducting financial
analysis. Such an analysis is helpful in taking informed decisions.
Fundamental analysis is a comprehensive approach which requires an extensive under­
standing of finance, accounting, and economics. A knowledge of the macroeconomic
indicators, analysis of financial statements and a knowledge of valuation techniques
is imperative for conducting financial analysis. A case study “Should you invest in the
stock market” at the end of the chapter will help in understanding the importance of
fundamental analysis in equity investment decisions.
In the fundamental analysis, the intrinsic value of a security is determined through the
fundamental analysis and is compared with its current market price. If the fair price of a
security which is determined through the fundamental analysis is higher than the market
value, we buy it. Conversely, if the fair price of the security is less than the market price,
we sell it.

Decision Criteria Recommendation

If IV > MV Buy
If IV < MV Sell
If IV = MV Fundamental Hold

There are two approaches for carrying out fundamental analysis:

(a) Top-down approach
(b) Bottom-up approach
While the top-down approach starts by analyzing the overall health of the economy
through understanding various macroeconomic indicators like GDP, inflation, industrial
development, and interest rates among others, it is followed by assessing the prospects of
various industries and sectors identifying the most promising investment opportunities.
After this, companies are analyzed based on their prospective profitability.
Figure 5.1: Top-down Approach

Economy

Industry

Company

On the other hand, the bottom approach focusses on individual stocks. It gives more
importance to microeconomic factors like earnings and growth of the company. 147
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Figure 5.2: Bottom-up Approach
NOTES

Economy

Industry

Company

The fundamental analysis is thus a combination of economic, industry and company

analysis in order to find a security’s current fair value and to forecast its future value. Such
analysis helps the investors in taking informed decisions.

5.1.2 CONCEPT OF BUSINESS CYCLE

Business Cycle or economic cycle refers to the economic fluctuations between periods of
expansion and contraction. A business cycle is characterized by stages of rise and fall in the
economy. Factors such as gross domestic product, interest rate, industrial development,
employment and disposable income of the customers can help in determining the current
economic cycle stage.

5.1.3 STAGES OF BUSINESS CYCLE

Boom: A boom is characterized by a period of rapid economic growth. During this period, the
economic activity increases. Key indicators like GDP, employment and credit growth rises.
This expansion stage is characterized by increasing production, industrial development, stock
prices and business profits. This period witnesses rising investments and money supply. The
economic growth rises marking a sense of optimism in the economy.
Peak: After some period, the economy reaches a saturation point or peak. It marks the end
of the expansionary phase. The economic indicators reach to their maximum. The second
stage is the reversal point in the trend of economic growth. Inflationary pressures may
start to build.
Recession: A period of stagnated growth is contraction or recession in the economy.
During this stage, there is a steady decline in demand followed by a fall in production.
Investments decline, unemployment rises, and consumer spending goes down. This phase
is marked by declining business profits and reduction in production.
Trough: The growth rate becomes negative at this stage. Economic indicators reach to their
lowest ebb. There is uncertainty and lack of confidence. Investments fall accompanied with
a fall in economic growth. This phase is followed by a recovery phase which is characterized
by a turnaround in the economy. Demand starts picking and supply increases. Moreover,
employment increases, credit growth expands, and investments rise.

148
Thus, this completes one full business cycle of expansion and contraction. The extreme
points within this cycle are peak and trough.
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Figure 5.3: Business Cycle
NOTES

Business Cycle

Peak Peak

Expansion Recession Expansion Recession

Depression Recovery

Trough

Source: www.corporatefinanceinstitute.com/resources/economics/business-cycle

CHECK YOUR PROGRESS – I

Tick the right answer:
1. Business Cycle reflects the rise and fall in the economic growth. (True/False)
2. The extreme points in a business cycle are trough and peak. (True/False)
3. Economic indicators reach to their lowest ebb during recession. (True/False)
4. Optimism in the economy is seen during boom. (True/False)
5. The interest does not indicate the current economic cycle stage. (True/False)

5.2 ECONOMIC INDICATORS

Economic Analysis is a set of macroeconomic factors affecting various industries and
companies. These factors have repercussion on the economy. For instance, growing GDP
signals economic prosperity and an increase in inflation is associated with dampened
sentiments in the market. The phrase “a rising tide lifts all boats” is often used to
understand the effect of a bull market on the majority of stocks. During a bullish phase,
most companies witness growth. As people perceive the economy to be strong, the
spending increases leading to more demand of goods and services. Companies ramp up
production to meet the increased demand. More are hired and employment increases
which in turn leads to a further increase in demand. Similarly, during contractionary
period, the overall demand is less which is accompanied by less production and high
unemployment. Individuals and companies cut back on production, expansion, and
diversification. This further leads to a fall in the economic growth. The expansion and
contraction in economic activity is called as Business cycle. The upswings and downswings
in economic activity–production, unemployment, income and sales are seen during
various phases of business cycle. An expansionary or booming period is followed by
economic contraction. After a period of slow growth, steps are taken to infuse growth in 149
the economy. The economy thus recovers and gradually enters into a phase of expansion
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NOTES which is evident from increased demand, rising output, increased per capita income and
sales. This cycle keeps on moving alternating between expansion and contraction which
is evident from Figure 5.4.

Figure 5.4: Stages of Business Cycle

Peak

Peak
Real GDP

Expansion
Contraction
Trough

Time

If an investor fails to do economic analysis before investing, it would be a mistake on his

part. It is important to understand the forces operating in the overall economy which
affects industries and stock prices in general. It is important to predict the course of the
economy as economic activities affects corporate profits leading to a fall in the stock
prices. Thus, there is a strong link between economic activity and the stock market.
Before an investor commits his funds, he must ensure that it is the right time to invest.
If he is confident that this is the right time to invest, he must decide on the various
avenues of investment like equity, debt, mutual funds, options among others. Short-
term economic forecasting techniques like surveys, diffusion index, indicators, etc.
must be carried out to assess the economy and the broad economic indicators. In order
to equip the investor to understand economic variables, the next section discusses the
economic measures.

5.2.1 ECONOMIC INDICATORS/MEASURES

A discussion on economic measures is a must to gauge the overall direction of the economy.
These are variables to assess and monitor various aspects of an economy’s performance
providing valuable insights of an economy.

5.2.2 GROSS DOMESTIC PRODUCT (GDP)

Gross Domestic Product (GDP) is the sum total of all goods and services manufactured in
the domestic territory of the country in a financial year. It measures the country’s output
and economic growth in the country. Similarly, Gross National Product (GNP) includes
GDP plus the income earned by residents from overseas investments minus the income
earned by foreign residents. A high GDP is a sign of economic prosperity while a decline
indicates a potential economic slowdown. Fig. 5.5 shows high volatility over the years
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indicating business cycles.
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In the year 2020–21 the sectoral contribution to GDP indicates that service sector has the NOTES
highest share among all the other sectors. The share of service sector is 53.89% of total
India’s gross value added, the manufacturing sector contributes 25.92% and some 20.19%
by the agriculture and allied sector.
Figure 5.5: GDP Growth Rate
Rate of Growth (%)
12

10

0
1951-52

1961-62

1971-72

1981-82

1991-92

2001-02

2011-12
1955-56
1957-58

1965-66
1967-68

1975-76
1977-78

1985-86
1987-88

1995-96
1997-98

2005-06
2007-08

2015-16
2017-18
1959-60

1969-70

1979-80

1989-90

1999-00

2009-10

2019-20
1953-54

1963-64

1973-74

1983-84

1993-94

2003-04

2013-14
–2
–4

–6

Source: Planning Commission, Government of India and Economic Survey 2018–19

Figure: 5.6: Economic Growth Post Pandemic

160 Real GDP FY20 Level Growth (RHS) 12

8
150

4
`Lakh Crore

Percent
140
0

130
–4

120 –8
FY20 FY21(1stRE) FY22(PE) FY23(FAE)

Source: Economic Survey 2022–23, Government of India

Fig. 5.6 shows the economic growth post pandemic. A full recovery is evident in FY2022
post pandemic.

5.2.3 SAVINGS AND INVESTMENT

Economic growth is dependent on savings and investment. It is the growth in savings
that lead to growth in investments. A higher investment is associated with increased
production, higher profit margins and an increase in stock prices. The various avenues
of savings include bank deposits, equity shares, debentures, post office deposits,
insurance, mutual funds, real estate, and bullion. Financial institutions channelize
the savings to investment. It is high savings rate in any economy which sustains high
growth. According to India Ratings & Research, the Indian economy needs both savings 151
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Economic Analysis
NOTES and investment rates close to 35% on a sustained basis for an 8% year-on-year growth.
Savings and investment rates in the financial year 2021–22 were 30.2% and 29.6%
respectively.

5.2.4 INTEREST RATES

The Marginal cost of Funds based lending rate (MCLR) determines the cost of
borrowed funds in India. MCLR is the minimum lending rate below which a bank is
not permitted to lend. A higher MCLR will lead to higher interest rates and thus higher
cost of lending for corporates and higher EMI for borrowers. Similarly, decrease in
interest rates implies low cost of finance for firms and more profitability and thus
increased stock prices.
The MCLR is calculated by banks on the basis of the following four components–Marginal
cost of funds, cash reserve ratio, tenure premium and operating costs.

5.2.5 INFLATION
Inflation denotes an increase in general price level. Demand induced inflation is called
as Demand-Pull Inflation and if the rise in price is attributed to an increase in cost of
production, it is termed as Cost push inflation. Two commonly used index to measure
inflation in India are Wholesale Price Index (WPI) and Consumer Price Index (CPI). It is
important to measure inflation to understand price change in the market and thus keep
a tab on inflation.
Inflation adversely affects the profitability of companies because of higher outflow
on interest cost. It also affects shareholders’ expected rate of return and directly
affects the discount rate. Increase in discount rate adversely affects stock prices and
lead to fall in the value of stocks. Moreover, inflation reduces disposable income
leading to fall in demand of goods and services. Production falls and thus there is fall
in economic growth.
Inflation is controlled through the dear monetary policy of RBI. RBI tries to control
inflation by increasing the repo rate (the rate of interest or cost levied upon public and
private banks for borrowing money from the apex bank), in order to control and supply
and demand of goods and services. Simultaneously, the increase in repo rates compels
banks to increase interest rates on loans and deposit rates.
The government, in the past, has announced a series of measures to ease inflation—cut
the excise duty on petrol and diesel, reduce import duty on key raw materials and crude
edible oils, to name a few.

5.2.6 FISCAL POLICY

Fiscal policy refers to the government’s expenditure and revenue sources. Government’s
spending supports economic growth and development in the country. By increasing
government spending, demand increases which further leads to an increase in
production. Thus, an increase in government spending is associated with more
investments in the economy. Conversely, if the government spending is less, there is
slowdown in the economy. The major source of government’s expenditure includes
money spent on provision of education, healthcare and defense. It also includes spending
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on social service schemes and subsidies. The major revenue source of the government NOTES
is classified into tax and non-tax revenue sources. Direct Taxes are taxes on income and
property. Indirect Taxes are taxes on commodities and services. As per Indian Union
Budget estimates for financial year 2023, direct taxes accounted for 51.5% and indirect
taxes accounted for 48.5% of total central tax collection in India. India’s net direct tax
collection for the period between April 1 and September 16, 2023, reached Rs. 8.65 lakh
crore, showing a growth of 23.5% on an annual basis. Non-tax revenue sources include
long-term and short-term borrowings, disinvestment, auction of telecom spectrum,
among others.
The difference between total revenue and total expenditure of the government is
termed as fiscal surplus/(deficit). Fiscal In the fiscal year 2023–24, the projected fiscal
deficit is set at 5.9% of the GDP, marking a decrease from the revised estimate of 6.4%
in 2022–23. The fiscal deficit, denoting the disparity between the government’s total
revenue and total expenditure, has seen a notable increase in India over the years. For
instance, it grew from Rs. 27,040 crore in 1988–89 to Rs. 5,42,499 crore in 2013–14.
This trend reflects the ongoing challenges and strategies in managing the country’s
fiscal affairs.
The two-pronged strategy for reducing fiscal deficit lies in Augmenting Revenue and
Controlling Non-Plan Expenditure.
For instance, an increase in tax rates would reduce disposable income thereby reducing
demand. A contraction in demand leads to reduction in production. Thus, all other things
remaining same, a contraction in government spending is indicative of falling economic
growth and vice versa.

5.2.7 MONETARY POLICY

Monetary policy is framed to regulate money supply in the economy by credit expansion
or credit contraction. Money supply is increased in the economy by expansion of credit.
This type of a policy is termed as cheap monetary policy. It is by curtailing credit that
the money supply is reduced. This policy is termed as dear monetary policy. A cheap
monetary policy is a sign of growing economy. Interest rates falls giving way to credit
growth. This in turn leads to increase demand for goods and services. Production too
increases to match the demand. On the other hand, a dear monetary policy indicates
reduced money supply by increasing interest rates. Credit growth is affected. Demand
falls down and this is followed by a fall in production. Thus, a dear monetary policy
reflects falling economic growth.

5.2.8 BALANCE OF PAYMENTS

The Balance of payment is a summary of all economic transactions between one country
and the rest of the world. The current account reflects the inflow and outflow of goods
and services into a country while the capital account marks the receipts and payments
related to investments and borrowings. Balance of payment is an important indicator of
an economy’s health.
If the receipts (credit) side is more than payments (debit) side, it indicates a favorable
balance of payment and thus a healthy sign of economic growth. However, if the receipts
(Credit) side is less than the payments (debit) side, it indicates an unfavorable balance of
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NOTES payment i.e. deficit in the country’s earnings. The latest Balance of Payment data for India
is provided below:
Figure 5.7: Balance of Payment data for India

Last Previous Highest Lowest

Balance of Trade −17.5 −19.8 0.71 −31.46 USD Billion Jan/24
Current Account −8300 −9195 19083 −31857 USD Million Sep/23
Current Account to −2 −1.2 2.3 −4.8 percent of Dec/22
GDP GDP

Source: tradingeconomics.com/india/indicators

CHECK YOUR PROGRESS – II

Tick the right answer:
1. Rising interest rates reflects cheap monetary policy. (True/False)
2. MCLR stands for Marginal Cost of Funds. (True/False)
3. If Intrinsic Value of a security is more than its market price, it’s time to sell the
security. (True/False)
4. Inflation is associated with the contraction phase of the business cycle. (True/False)
5. Economic analysis helps predict future economic conditions with absolute certainty.
(True/False)

5.3 LEADING, LAGGING AND COINCIDENT INDICATORS

Economic indicators are studied to find out future performance of the economy.
These indicators detect the business cycles and can be used to judge the overall health
of the economy. They are used by investors to predict the future growth of the economy.
The indicators are valuable in finding out the direction of economic activity. However, it
fails to give any idea on the magnitude of change.

5.3.1 LEADING INDICATORS

Leading indicators reach their peaks and their troughs before a change in the
economic activity. They forecast the direction of the economy. For instance, the type
of monetary policy–dear or cheap indicates in advance the contraction or expansion
of economic growth in the country. Other leading indicators can be monsoon. A good
monsoon is accompanied by higher growth rates. Fiscal policy which chalks the revenue
and expenditure of the government is a leading indicator. A rise in the government
expenditure indicates higher economic growth. On the other hand, rise in taxation
structure, reduced government spending and fiscal deficit indicates fall in economic
prosperity.

5.3.2 CONCURRENT INDICATORS

Concurrent indicators reach their peaks and troughs at around the same time as the
economy. GDP and industrial production can be taken as coincidental indicators. Low
economic growth and industrial production simply highlights that economy is hit by
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5.3.3 LAGGING INDICATORS NOTES
Lagging Indicators reach their peaks and trough once the economy has already reached.
its own. They reach their turning points once the economy has reached its own.
Unemployment, Consumer Price Index and gross non-performing assets ratio are few of
the lagging indicators.
While the Leading Indicators provide an early indication of significant turning points in
the business cycle and where the economy is heading in the near term, the coincidental
indicators provide an indication of the current state of economy. Lagging indicators are
metrics to assess the effect of economic growth.
The Bureau of Economic Analysis, US Department of Commerce provides data on index
of economic indicators. In January 2023, the Composite Leading Indicator for India rose
from 99.65 points in December 2023 to 99.66 points. From 1994 to 2024, the Composite
Leading Indicator in India averaged 100.00 points. It peaked in February 2000 at 104.20
points and fell to a record low of 69.91 points in April 2020.
Leading Indicators:
• Money Supply (M2)
• Average weekly hours of manufacturing production workers
• Manufacturers new orders
• Vendor performance
• Stock prices
• Purchasing Managers’ Index
Coincidental Indicators:
• Industrial Production
• Manufacturing and trade sales
• Personal income less transfer payments
• Employees on nonagricultural payrolls
Lagging Indicators:
• Average duration of unemployment
• Ratio of trade inventories to sales
• Average prime rate charged by banks
• Change in consumer price index for services

The above list is not exhaustive. There are other indicators too. At times, the economic
indicators are not correctly interpreted. Sometimes, the data related to a particular
indicator is not available at the right time. Certain measures may give conflicting signals in
terms of future direction of the economy. So, one cannot rely on a certain set of indicators
to predict the cyclical movements in the economy.
A combination of indicators or a composite indicator can be used to assess the economy.
This is made by combining a number of indicators in one single index–Diffusion Index. The
diffusion index consists of selected leading, lagging, and coincidental indicators. It measures
how widespread economic activity is across different sectors and types of economic activity.
Diffusion indicates whether the economy is weakening or if there are just isolated pockets 155
of weakness which does not translate into a broad downturn in overall economic activity.
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NOTES The downward movement is found out three parameters–Duration, depth and diffusion.
Duration is how long-lasting a decline in the index be while depth denotes how large the
decline is. Both duration and depth are measured by the rate of change in the index over
the last six months. Diffusion is a measure of how widespread the decline is. Usually, the
index ranges from 0 to 100 and numbers below 50 indicates most indicators are falling.
The diffusion index provides valuable information about impending recessions.
The greater the suggested rate of change, the farther the index is from the value that
would indicate “no change” (50 points). Consequently, a quicker rate of growth is indicated
by an index value of 58 than by a value of 53, and a faster rate of fall is indicated by an
index value of 40 than by a value of 45. All respondents report higher activity when the
number is 100, but all respondents report lower activity when the value is 0. The indicator
for Indian economy is provided below:

Figure 5.8: India Business Confidence Index

56
Growth

54

52

50

48
Mar-21 Sep-21 Mar-22 Sep-22 Mar-23 Sep-23 Mar-24

Source: World Economics

Note: Data Shown as a Diffusion Index. (50 = ‘No Change’, above 50 = Increasing growth, below 50 =
Declining growth)

It gives a clear picture of where the economy is headed. However, it is also beset with
limitations. Indicators may at times give mixed signals thus making the entire process
redundant.

CHECK YOUR PROGRESS – III

Fill in the Blanks
1. ____________________ is a composite indicator to assess the economy.
2. Vendor performance is a ______________________ indicator.
3. _______________________ indicators reach their peaks and troughs at around the
same time as the economy.
4. The diffusion index ranges from 0 to _______________.
5. Money supply is a ____________________ indicator.

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5.4 FORECASTING ECONOMIC OUTLOOK NOTES
It is essential to forecast economic performance for carrying out economic analysis.
There are a number of forecasting techniques. Depending upon the duration, forecasting
can be short-term, intermediate or long term. Short term is from one to three years.
Intermediate term is between 3 to 5 years while long term is made from 5 years to
10 years or even more. Under short-term forecasting techniques, the most commonly
used techniques include Anticipatory survey, barometric or indicators approach and
econometric model building approach.

5.4.1 ANTICIPATORY SURVEY

This is one of the simplest technique through which experts in diverse fields are asked to
give their opinion on the future prospects of the economy. The experts are asked their
opinion with regard to plant and machinery expenditure, construction activities, inventory
management, etc. which have significant effect on the economic activities in the country.
Such surveys also incorporate the purchase intentions of the consumer.
The major shortcoming associated with such an approach is biasedness. Experts may be
biased on certain issues, and they differ on the same set of problem. Survey results cannot
be regarded as forecasts. They are merely opinions. Moreover, the external environment
which is to an extent uncontrollable can affect the intentions of consumer.

5.4.2 BAROMETRIC OR INDICATOR APPROACH

Another forecasting tool is the barometric or indicator approach. In this approach,
various indicators are studied which are effective in predicting the future growth of
the economy. These indicators can be broadly classified as Leading, Coincidental and
Lagging indicators.

5.4.3 ECONOMIC MODEL BUILDING APPROACH

It is one of the most logical and scientific approach in determining the relationship
between endogenous and exogenous variables. Exogenous variables are independent
and endogenous variables are dependent. Econometrics is the field of study that applies
mathematical and statistical techniques to economic theory. Economic forecasting
techniques predict the economy very precisely by establishing links between independent
variables with dependent variables. The independent variables used to predict economy
can be interest rates, gross domestic product, inflation, bond yield, stock market
performance among others. The forecasts derived from such an analysis depends upon
the reliability of data and assumptions made in the study.
A widely used model is the Opportunistic Model Building or GNP Model Building or
Sectoral Analysis. The steps involved in this approach includes:
(a) Initially, the forecaster presumes the total demand and total income during
the forecast period based on possible scenarios like war, political instability,
inflation, etc.
(b) Then the forecaster estimates GNP by determining the levels of various
components of GNP like Gross private domestic investment, government
purchases of goods and services and net exports. Gross private investment 157
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NOTES is classified into business expenditures in plant and equipment, residential
construction and change in level of stocks.
(c) After this, the forecaster estimates the personal consumption. This sector is
divided into three components–durable goods minus automobiles, automobiles
and non-durable goods and services. Estimating personal consumption helps
the forecaster in finding relationship between personal disposable income and
expenditure on durable and non-durable goods and services.
(d) Once the estimates for all four components of GNP are ready–Gross private
domestic investment, government purchases of goods and services, net exports,
and personal consumption it is added to get the forecasted figure of GNP.
(e) The forecaster then compares his dataset with the independently arrived at a
priori forecast of GNP. The overall forecast is also tested for internal consistency.
Through this, the forecaster ensures that his total forecast and subcomponents
forecast makes sense and fit together.
Thus, an opportunistic model building is one of the most versatile models of forecasting.
It requires accuracy of data plus a vast amount of judgement and inequity for a
comprehensive forecast.
Econometric Model building suffers from several limitations:
(i) Data required for such an analysis is difficult to get.
(ii) Such an analysis requires trained and skilled manpower.
(iii) It is a time-consuming exercise and delays can make the whole process redundant.
(iv) The forecaster must not accept the forecasts blindly rather all efforts should be
made to critically evaluate each and every aspect of the forecast.

CHECK YOUR PROGRESS – IV

Tick the right answer:
1. Barometric approach is the use of indicators in predicting economic growth.
(True/False)
2. Econometric Model building establishes relationship between endogenous and
exogenous variables. (True/False)
3. Barometric approach is also known as Indicators approach. (True/False)
4. Survey method is one of the most logical and scientific approach in determining the
relationship between endogenous and exogenous variables. (True/False)
5. Anticipatory Survey method is prone to biasedness. (True/False)

5.5 LET US SUM UP

• The concept of Fundamental Analysis is discussed with the importance of Economy-
Industry-Company framework in conducting financial analysis.
• This unit explains the Economic Analysis which is one of the constituents of
Fundamental Analysis.
158 • Various economic variables – Interest rates, savings and investment, GDP, Fiscal Deficit,
Industrial development have been thoroughly discussed to understand the growth of
economy.
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• Short-term forecasting techniques – Anticipatory surveys, barometric approach and NOTES
econometric model building approach were also explained in detail to predict the
future course of growth of economy.
• The unit concludes with a case study on key attributes required for successful investing
in stock market.

5.6 KEYWORDS
Business Cycle: Economic fluctuations between period of expansion and contraction.
Fundamental Analysis: A method to assess intrinsic value of a stock by studying economy,
industry, and company.
Economic Analysis: A set of macroeconomic factors affecting various industries and
companies.
Marginal Cost of Lending Rate (MCLR): Minimum lending rate below which a bank is not
permitted to lend.
Fiscal Policy: A policy of government’s expenditure and revenue sources.
Monetary Policy: A policy which regulates money supply in the economy by credit
expansion or contraction.
Balance of Payment (BOP): Summary of a country’s transaction with the rest of the world.
Diffusion Index: A combination of indicators to assess the economy.

5.7 SELF-ASSESSMENT QUESTIONS

Multiple Choice Questions
1. What is the primary aim of fundamental analysis?
(a) It aims to determine a stock’s fair market value.
(b) It aims to understand the consumers’ choice.
(c) It is done to assess the market conditions.
(d) None of the above
2. What kind of approach is the E-I-C framework?
(a) Bottom-up
(b) Top-down
(c) Both
(d) None of the above
3. What is Gross Domestic Product?
(a) Wages received by workers
(b) Value of goods and services manufactured in a country
(c) Per capita income of residents of a country
(d) Average savings of households 159
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NOTES 4. What is the aim of dear monetary policy?
(a) To increase money supply in the country
(b) To stabilize macroeconomic conditions in the country
(c) To decrease money supply in the country
(d) None of the above
5. Which among the following is a leading indicator?
(a) Index of industrial production
(b) Change in consumer price index
(c) Money supply
(d) Manufacturing and trade sales
6. Why are short-term economic forecasting techniques used?
(a) To predict monsoons in India
(b) To ascertain stock market behavior
(c) To understand business cycles
(d) To predict the economic growth
7. Which of the following is not a economic forecasting technique?
(a) Anticipatory Surveys
(b) Wholesale price index
(c) Barometric Approach
(d) Econometric Model building approach
8. Which of the following is not a measure of economic activity?
(a) Inflation
(b) Monsoon
(c) Index of Industrial production
(d) Capital Structure
9. What do you mean by the term fiscal deficit?
(a) Excess of government’s expenditure over revenue
(b) Excess of government’s revenue over expenditure
(c) Lack of short-term borrowings
(d) Lack of government spending on key sectors
10. What is Marginal cost of funds?
(a) The cost of getting funds by banks
(b) Minimum lending rate below which a bank is not permitted to lend

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(c) Minimum time period to repay a loan
(d) None of the above
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CASE STUDY: SHOULD YOU INVEST IN THE STOCK MARKET? NOTES

There are many investment options in which you can park funds based on your goals–
FDs, FDs, RDs, NSC, NBFC deposits, mutual funds. But what about the stock market?
With a bull market on, many folks around you seem to be making (or claiming to make)
big returns from stocks.  
The social media is full of folks claiming that the ₹10,000 they invested in so-and-so
stock has today turned into many lakhs or even crores. But they sure don’t tell you
about the many stocks where they invested ₹10,000 and lost their shirt!  
The main thing for investors to understand, before stepping into the stock market, is
that this is an asset that can multiply your money, or decimate it, depending on your
timing and stock selection skills. Investing directly in stocks is not for everyone. To do it
successfully, you need four attributes.  
Risk appetite
Though there are many textbook methods to assess risk, the most practical one is to
honestly assess how much capital you’re willing to lose. In other investments like bank
FDs or post office schemes, you may make a lower or higher return but you (mostly)
don’t lose your principal. In stocks, losing your principal is a commonplace occurrence.  
So the first thing you need to invest in stocks, is the ability to take losses to your
principal. Veteran investors will tell you about market crashes like the one in 2000 or
2008 where they lost 80 per cent or 90 per cent on some of the popular stocks of the
era. Even if you manage to avoid such mishaps, if you invest in an overheated market,
you can lose 40–50 per cent of your capital. Don’t forget that the Indian market, at the
index level, fell over 50 per cent in 2008 and over 40 per cent in 2020.
Ability to hang on
If the markets have the habit of crashing by 40–50 per cent sometimes, how do some
people make big returns on stocks? Well, they do it by simply hanging on through these
crashes and waiting for the next bull market to arrive. Stock prices move in cycles.
But in the long run, they keep up with the earnings of companies that make up the
market. In a growing economy like India, stocks tend to face high short- term volatility
but over the long run, if you look at the Sensex or Nifty graph, the big crashes are blips
on the radar.
For you to brush off the big crashes and view corrections as mere blips to your portfolio,
you need to hold stocks over a long horizon. Now some folks may tell you that a 3 year
or 5 year holding period is enough to mint money from stocks. But a more realistic
horizon to survive crashes and to come back, is 7 years or more. Investors who lost
money in the dotcom crash of 2000 had to wait until 2004 to get back to break even.
Those who invested in end-2007 had to wait until 2014 before they could get back to
the green. So while investing in stocks, be prepared not to take that money out for the
next 7 years or more.
Knowledge of business and finance
The examples that you see of banks, paint companies etc. multiplying some investor’s
money in ten years, are loaded with survivorship bias. What’s that? These are examples 161
of stocks that survived market crashes and made it out unscathed. And therefore, were
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NOTES able to multiply money. For every paint stock or consumer stock that has gone up 5
times or 10 times, there are dozens of examples of infrastructure stocks or power
stocks that have made investors’ money disappear in the last 10–15 years. It is not easy
to know, without the benefit of time travel, which stocks will make it big over the next
ten years, and which will vanish without a trace.
The only way to get good at this prediction is to understand the business you’re
investing in like the back of your hand. When you invest in a stock the main call, you’re
taking is that the company will manage to multiply its profits over time. Evaluating
this requires the ability to understand industries and business and economic cycles,
apart from the profit drivers and risks to the business you’re investing in. To identify
rogue companies, you need serious balance sheet reading skills. To estimate where a
company’s profits may go in future, you need forecasting and modelling skills.  
Time to spare
Finally, many folks think of making money from stocks as a sort of hobby, a part-time
endeavor. But to be really successful at investing and trading, markets, companies,
businesses etc. need to be your passion. Look at any successful investor or trader and
you’ll see that they are professionals, fully immersed in this world of companies and
markets 24/7. To earn good long term returns from stocks, you need to track their
financial performance, corporate actions, competitors and also external factors like
policy and regulatory developments.  
Few folks with a full-time job will have time or the energy to do all this. That’s why
mutual funds have become so popular!
Analyze key attributes required for investing in stock markets. What do you think is
the role of fundamental analysis in equity investment decisions?
Business Line, October 27, 2023

5.8 REFERENCES AND SUGGESTED ADDITIONAL READINGS

1. Fischer, D.E. and Jordan, R.J, Security Analysis and Portfolio Management, Sixth
Edition, PHI, New Delhi
2. Kevin, S., Security Analysis and Portfolio Management, Third Edition, PHI

5.9 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. True
2. True
3. False
4. False
5. False
Check Your Progress – II
162 1. Diffusion
2. Leading
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3. Coincidental NOTES
4. 100
5. Leading
Check Your Progress – III
1. True
2. True
3. False
4. True
5. False
Check Your Progress – IV
1. True
2. True
3. True
4. False
5. True

5.10 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (a) 2. (b) 3. (b) 4. (c) 5. (c)
6. (d) 7. (b) 8. (d) 9. (a) 10. (b)

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INDUSTRY ANALYSIS

STRUCTURE
6.0 Objectives
6.1 Introduction
6.2 Porter’s Five Forces Model
6.3 Industry Life Cycle
6.4 Industry Characteristics
6.5 Cyclical Industries
6.6 Defensive Industries
6.7 Growth Industries
6.8 Let Us Sum Up
6.9 Keywords
6.10 References and Suggested Additional Readings
6.11 Self-Assessment Questions
6.12 Check Your Progress – Possible Answers
6.13 Answers to Self-Assessment Questions

6.0 OBJECTIVES
After reading this unit, you will be able to:
1. explain the relevance of industry analysis for equity investment decision.
2. understand the factors that have the most significant effect on an industry’s
earnings.
3. explain the concept of industry life cycle and its role in industry analysis.
4. classify industries into growth, cyclical and defensive industries.
5. understand the techniques to analyze industries.

RECAP OF UNIT 5
In the previous unit, we discussed the notion of Fundamental research and its importance
within the framework of the Economy-Industry-Company method to doing complete
financial research. Economic Analysis was a crucial component investigated, revealing 165
different economic factors such as interest rates, savings and investment, GDP, fiscal
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Industry Analysis
NOTES deficit, and industrial development. By thoroughly investigating these characteristics, we
hoped to get insight into the economy’s overall growth trajectory. The unit also provided
a full overview of short-term forecasting strategies, such as anticipatory surveys, the
barometer approach, and the econometric model building approach, all of which are useful
in projecting the future trajectory of economic growth. The unit finished with a case study
focusing on the basic characteristics required for successful investing in the stock market,
delivering practical insights for investors to consider in their decision-making process.

6.1 INTRODUCTION
Fundamental analysis is a valuation technique used by stock analysts to determine whether
a stock is overvalued or undervalued. Fundamental analysis uses E-I-C framework in order
to find out the true or fair price of a stock. The economic analysis gives an indication of the
direction of the economy. The next step after conducting economic analysis is charting the
growth of a number of industries in which one can think of investing.
An industry is a group of firms that produces closely related goods and services. A group
of companies manufacturing paper products are part of paper industry.
Industry analysis is assessing the industries for their overall performance and growth.
Industries differ in terms of their risk and return. The risk and profitability associated
with the pharmaceutical industry is different from steel industry or for that matter the
opportunities and threats of cement industry will differ from automobile industry. Therefore,
it is imperative for stock analysts to study the prospects of an industry before investing.
There are various techniques used for analyzing industries.

6.1.1 INDUSTRY REPORTS

Industry reports are vital resources for analyzing industries since they offer extensive
insights into numerous facets of a certain industry. Typically, research firms, financial
institutions, or government organizations generate these reports, which contain a
substantial amount of information that might assist in making strategic decisions. Industry
reports function as a method for analyzing industries.
• Market Overview: Industry reports offer a comprehensive analysis of the market,
encompassing its dimensions, patterns of growth, primary catalysts, and obstacles.
This data assists analysts in comprehending the present condition of the industry
and its prospects for expansion or contraction.
• Competitive Landscape: Industry studies assess the competitive landscape by
identifying prominent participants in the industry, their market share, competitive
strategies, and strengths and weaknesses. This study aids stakeholders in evaluating
the competitive dynamics within the market and devising efficient tactics to get a
competitive edge.
• Regulatory Environment: Industry reports analyze the regulatory framework that
governs the sector, encompassing pertinent laws, regulations, and government
policies. Gaining a comprehensive understanding of the regulatory framework is
essential for evaluating the obligations related to compliance, recognizing potential
regulatory hazards, and predicting potential industry-altering modifications.
• Technological Trends: Industry reports emphasize the impact of technology
166 breakthroughs and innovations on the sector, including new technologies,
digitalization trends, and disruptive innovations. Examining technological trends
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enables stakeholders to discover prospects for innovation and investment in NOTES
technology-based solutions.
• Supply Chain Analysis: industry reports offer valuable insights into the intricate
dynamics of the supply chain within the sector, encompassing suppliers, manu­­
facturers, distributors, and retailers. Gaining a comprehensive understanding of
the supply chain allows stakeholders to evaluate the effectiveness, dependability,
and capacity to recover from disruptions, as well as suggest possibilities for
improvement.
• Market Segmentation: Market segmentation is dividing the market into several
groups based on factors such as product type, end-user sector, region, and market
segment. This process of segmentation assists stakeholders in identifying target
markets, evaluating market demand, and customizing their strategy to suit certain
market groups.
• Financial Performance: Industry reports provide an analysis of the financial
performance of firms within the industry, focusing on important financial
parameters such as sales, profit margins, return on investment, and financial ratios.
Evaluating financial performance enables stakeholders to assess the profitability,
efficiency, and financial well-being of companies in the industry.
• Risk Assessment: Industry studies indicate possible hazards and difficulties that the
industry may encounter, such as economic recessions, geopolitical uncertainties,
interruptions in the supply chain, and threats from competitors. Examining
potential hazards enables stakeholders to formulate risk reduction strategies and
backup plans to tackle any difficulties.

Industry reports are essential tools for analyzing industries as they offer complete insights
into market dynamics, competitive landscape, regulatory environment, technology
developments, supply chain dynamics, market segmentation, financial performance,
and risk assessment. By utilizing industry reports, stakeholders may make well-informed
decisions, uncover potential areas for expansion, and minimize risks in the always changing
business environment.

6.1.2 PRODUCT DEMAND ANALYSIS

Product demand analysis is an essential method for examining industries as it offers
valuable insights into customer preferences, market trends, and the determinants of
product demand. Product demand analysis is a technique used to analyze industries.
1. Comprehending Consumer Preferences: Product demand analysis facilitates
comprehension of customer preferences through the examination of elements
such as demographics, psychographics, purchasing behavior, and buying
patterns. Through the analysis of customer preferences, industries may
ascertain the items that are now sought after, the specific characteristics and
qualities that attract consumers, and the growing patterns that influence
consumer behavior.
2. Market Segmentation: Market segmentation is enabled by product demand
analysis, since it helps identify different client segments based on their specific tastes,
demands, and purchasing patterns. Through the process of market segmentation,
industries may customize their goods and marketing tactics to efficiently target 167
certain client categories, ultimately maximizing sales and profitability.
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NOTES 3. Forecasting Demand: Forecasting demand involves analyzing past sales data,
market trends, economic indicators, and external variables that affect product
demand. This study helps firms predict future demand for their products. Precise
demand forecasting enables enterprises to optimize production, inventory
management, and resource allocation in order to meet projected demand levels
and prevent shortages or surplus inventories.
4. Analysis of Competition: Examining product demand yields valuable information
about rivals’ products, market placement, pricing tactics, and consumer
contentment levels. Industries can analyze the demand and performance of their
goods in relation to their rivals’ to determine their competitive strengths and
weaknesses. This analysis allows them to measure their performance against
industry benchmarks and find potential areas for differentiation and gaining a
competitive edge.
5. Identifying Growth Opportunities: Product demand research enables enterprises
to find development possibilities by pinpointing untapped market niches, unmet
consumer wants, and emerging trends that have significant growth potential.
Industries may enhance their market share, penetrate new markets, develop
novel goods, and broaden their product range to stimulate revenue growth and
profitability by taking advantage of these possibilities.
6. Fluctuations and Patterns Over Time: By studying product demand, companies
may discover seasonal fluctuations and patterns in customer behavior,
including periods of high demand, vacation seasons, and evolving preferences
over time. Industries may optimize their production, marketing, and inventory
management strategies by predicting seasonal changes and trends. This allows
them to take advantage of high-demand times and reduce risks during
low-demand seasons.
7. Price Sensitivity and Elasticity: Product demand research enables companies to
get insights into price sensitivity and elasticity by studying the impact of price
fluctuations on customer demand and purchasing patterns. Industries may
enhance their pricing strategies, establish competitive rates, employ promotional
pricing methods, and maximize revenue and profitability by undertaking price
sensitivity research. This can be achieved while still ensuring consumer loyalty
and satisfaction.
Product demand analysis is an essential approach for examining industries as it offers
significant insights into customer preferences, market dynamics, competitive environment,
growth prospects, seasonal fluctuations, price sensitivity, and trends. Through the
utilization of product demand research, industries may make well-informed decisions,
formulate targeted marketing strategies, optimize resource allocation, and improve their
competitive position in the marketplace.
This is a technique to determine customer demand for the production output of a certain
industry. We try to find out the factors that lead to increase or decrease in demand. Factors
that are responsible for change in the demand includes per capita income, disposable
income, inflation, price elasticity, credit growth, consumers’ expectations, etc.

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6.1.3 INPUT-OUTPUT ANALYSIS NOTES
Input-output analysis is an economic model that delineates the interconnected interactions
among different industrial sectors in an economy. It demonstrates the interdependence
of sectors, with the results of one area serving as inputs for another industry. Wassily
Leontief, a Soviet-American economist, devised the input-output analysis technique,
which led to his receipt of the Nobel Prize in Economics in 1973.
An industrial sector can function as both a recipient of the products and a provider of
the resources for other sectors within an economy. The input-output analysis paradigm
delineates the intricate and mutually reliant connection between variables.
This kind of analysis reflects the flow of goods and services through the economy.
The entire supply chain is analyzed right from the procurement of raw material to final
consumption. This is presented in the form of a table to analyze any change at every stage
and not just the final stage of consumption. Such an analysis is useful in understanding
inter-industry relationship.

CHECK YOUR PROGRESS – I

Tick the right answer:
1. Strengths and weaknesses are the internal factors. (True/False)
2. The degree of competition depends upon the growth rate of the industry. (True/False)
3. A group of automobile companies together account for the automobile industry.
(True/False)
4. Product demand analysis reflects the flow of goods and services through the
economy. (True/False)

6.2 PORTER’S FIVE FORCES MODEL

Among the other techniques of industry analysis, the Five Forces model holds
prominence. It was first described by Michael Porter in his classic 1979 Harvard
Business Review article. A Five Forces analysis can help investors assess industries
worth investing in. the competitiveness and profitability of any industry can be mapped
through such an analysis.
1. Threat of new entrants: This force assesses the probability of new entrants
joining the sector. The danger of new entrants is influenced by factors like as
obstacles to entry, economies of scale, brand loyalty, government laws, and
access to distribution channels. Industries characterized by substantial capital
needs or strong brand loyalty have lower susceptibility to new competition due
to high barriers to entry.
2. Threat of substitutes: This force evaluates the presence and desirability of
alternative items or services that can fulfil comparable client requirements.
The danger of alternatives is influenced by factors such as the trade-offs
between price and performance, the expenses associated with switching,

169
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Industry Analysis
NOTES and the loyalty consumers have towards a certain brand. Industries that have
easily accessible alternatives or little costs associated with switching are more
susceptible to competition from replacement products. This can result in
reduced profitability and market share.
3. Bargaining power of suppliers: This analysis assesses the influence of suppliers
in determining pricing, terms, and supply circumstances. Supplier power is
influenced by factors such as supplier concentration, input differentiation, and
switching costs. Industries characterized by a limited number of suppliers or
distinctive inputs encounter more pressure from suppliers to increase prices or
restrict supply.
4. Bargaining power of buyers: This force evaluates the customers’ ability to
bargain for pricing, quality, and buying conditions. Buyer power is influenced by
factors such as the concentration of buyers, price sensitivity, switching costs, and
availability of replacements. Industries characterized by a significant number of
consumers or minimal barriers to switching have increased buyer demand to
reduce prices and enhance quality.
5. Rivalry among the existing firms: This force assesses the degree of rivalry
among established companies within the sector. Competitive rivalry is
influenced by factors such as the rate of industry growth, the concentration of
rivals, the level of differentiation, and the presence of exit obstacles. Industries
characterized by sluggish development, significant market dominance, or little
product distinctiveness encounter fierce rivalry, resulting in pricing conflicts and
assertive marketing strategies.

Figure 6.1: Porter’s Five Forces Model

Threat of
Substitute
Products or
Services

Bargaining Power Rivalry Among

Bargaining
of Suppliers Existing
Power of Buyers
Competitors

Threat of New
Entrants

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An example of Porter’s 5 Forces sourced from Harvard Business School is provided below: NOTES
Figure 6.2: An Example of Porter’s 5 Forces Sourced from Harvard Business School

171

Source: https://www.isc.hbs.edu/strategy/business-strategy/Pages/the-five-forces.aspx
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NOTES We can find a case study at the end of this unit on Hero Moto Corps. Students can
assess the competitiveness of this companies using the above discussed Porter’s Five
Forces Model.

CHECK YOUR PROGRESS – II

Tick the right answer:
1. Porter’s Five Forces analyzes the phases of an industry. (True/False)
2. When the number of suppliers is more, their bargaining power is high. (True/False)
3. The Five Forces model assesses the competitiveness and profitability of industry.
(True/False)
4. There is no role of buyers in Industry analysis. (True/False)

6.3 INDUSTRY LIFE CYCLE

Industry Life Cycle depicts the stages through which businesses go through in a particular
industry. The distinct stages include–Pioneering, Rapid Growth. Maturity and Declining
stage. The industry life cycle concept was given by Julius Grodinsky. The industry life cycle
is broadly divided into four main stages:
• Pioneering or Introduction Stage
This is the first stage in the industrial life cycle of a new industry. The product is
new, and the technology is in its nascent stage. There is demand for the product
and this attracts producers to the industry. This stage is marked by intense
competition. Producers try differentiating products, develop their brand name and
image. Mortality rate is high as only few survive the competition. Only those which
survive the onslaught of competition remains in the industry. Rest others exit and
fails to survive the intense rivalry. The decision pertaining to investment is difficult
as the survival rate of the companies is unknown.
Example: Electric vehicles, Solar Panels, 3 D Printing, Driverless Cars are examples
of evolving industries.
• Rapid Growth Stage
The firms that survived from the pioneering stage dominate the industry. Demand is
still high leading to an increase in profitability and market share for the firms.
With a stable growth rate, many companies declare dividends. It is advisable to
invest in the share of these companies. This stage is characterized by high growth
rate which is higher than the average industry growth rate.
Example: Generative AI, Smart Fitness Wearables, Yoga and fitness Services, Health
Food etc. are examples of businesses in rapid growth phase.
• Maturity and Stabilization Stage
In the maturity and stabilization stage, the growth rate slows down. This stage where
the growth slows down is also called as “Shake-out” stage. Growth rate equals the
industrial growth rate or the gross domestic product rate. Sales may be rising but
the rate of increase falls down. Grodinsky termed this stage a “lateral obsolescence,”
a situation where signs of decline emerge. There may be technological obsolescence
172 and to avoid this, firms may go for technological innovations. Investors are cautious
during this stage and look for signs before any investment.
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Example: Smart Phones, laptops etc. are examples of businesses in maturity or NOTES
stabilization phase in which many players are there in market, demand is mainly
driven by replacement demand and product differentiation is being used as a
strategy to increase market share.
• Declining Stage
The last stage of industry life cycle is the decline stage. Demand for the product and
the earnings of the company decline in this stage. Change in tastes and preferences
of the consumer and change in technology are the primary reasons behind the fall
in demand. The industry thus grows less than the average growth of the economy
even during periods of boom. It is better not to invest in such industries as it would
lead to erosion of capital.
Figure 6.3: Industry Life Cycle
Introduction Growth Maturity Decline
Sales

Time

Example: Landline Telephones, Desktop Computers are examples of businesses in

declining stage.
The above discussion on industry life cycle holds significance as it provides investors to
make decisions on the timing of investments. Industry life cycle analysis is crucial for
investors to find out the stage of industry in which they intend to invest. Apart from
understanding the phases of industry, one must also understand the features and
challenges associated with different industries. Every industry is affected by different set
of factors in its environment. What may be good for an industry might not work well
for another industry. Thus, understanding industry life cycle may help the investors in
detecting opportunities and threats associated with investing.

CHECK YOUR PROGRESS – III

1. The __________ stage of the industry life cycle is characterized by intense

competition and high mortality rates among companies.
(a) Maturity
(b) Rapid Growth
(c) Pioneering
(d) Declining
173
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NOTES 2. During the Rapid growth stage, many companies declare __________ as demand
and profitability increase.
(a) Bankruptcy
(b) Dividends
(c) Losses
(d) Market exits
3. In the Maturity and Stabilization stage, the growth rate slows down and is often
referred to as the “__________” stage.
(a) Rapid Growth
(b) Introduction
(c) Shake-out
(d) Pioneering
4. The Pioneering or Introduction stage of the industry life cycle is marked by low
competition and a high survival rate among companies.
(a) True
(b) False
5. In the Rapid growth stage, companies in the industry experience a growth rate
lower than the average industry growth rate.
(a) True
(b) False

6.4 INDUSTRY CHARACTERISTICS

There are some other characteristics apart from industry life cycle which must be studied
by the investors to make careful decisions.

6.4.1 GROWTH OF THE INDUSTRY

The growth of an industry can also be predicted from its past performance. The historical
time series and forecasts provided by various research providers. One such research
entity is CMIE Industry Outlook. The CMIE Industry Outlook provides detailed information
for Indian industries that include mining, manufacturing, utilities, and service
industries. Industry Outlook enables to forecast trends in 209 industries. It provides
data on capacity, production, foreign trade, sales, prices, annual and quarterly financial
performance of the industry. Further, it also gives details on expansion plans of the
industry, performance of listed companies and projects expected to be commissioned
in the coming months.
Industrial data can also be tracked through the Annual Survey of Industries and
industrial outlook surveys carried by RBI from time to time. Apart from this, reports
from consultancy firms like KPMG or other independent researchers may help in
understanding the past performance and predicting the future growth of an industry.
Fig. 6.2 highlights the projected performance of cement industry in India. Kanvic’s
174 Cement Demand Projection Model specifically developed for Indian Cement Review
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Vision 2030 shows that demand for cement in India will increase by 116% by 2030 to NOTES
660 mn metric tons (MMT) at a CAGR of 6.6%. The primary reasons for the rise can be
attributed to growing infrastructural requirements in the country and the government’s
push on Housing for All.
Thus, these help investors in getting a near to medium term review of Indian industries.
Figure 6.4: Projected cement demand (MMT) and per capita consumption (kg), 2018–2030

Demand CAGR
6.6%

660

441

305

2018 2023 2030

Per Capita
Consumpon
226kg 309kg 434kg

Source: Kanvic Cement Demand Projection Model, 2018

6.4.2 COST STRUCTURE

The cost of production affects the profitability of industries. The cost may be divided
into fixed costs and variable costs. The one which remains fixed with a given level of
production is fixed costs and the one which varies with production is variable costs.
Some industries like iron and steel have high fixed costs compared to variable costs.
If the industry’s cost structure consists of mostly fixed costs, it implies that it has high
Operating Leverage.
Industries with high operating leverage have a greater proportion of fixed costs. The more
the fixed costs, the more sales have to be generated to reach its break-even point as the
fixed costs remain the same irrespective of volume of production. On the other hand,
industries with more variable cost component are flexible and can thus easily adjust to
the changing demand.
An investor before investing in a particular industry must be aware of the cost structure
and operating leverage of the industry. The investor must understand the elements
of cost–Direct and Indirect Cost (Overheads). He must have a fair idea of the installed
capacity and the idle capacity. 175
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NOTES 6.4.3 EXAMPLE OF FIXED OPERATING COSTS
Let’s consider a manufacturing company that produces automobiles. The fixed operating
costs incurred by this company may include:
• Facility Rent or Mortgage Payments: The company owns or leases a manufacturing
plant where it produces automobiles. The monthly rent or mortgage payments for
the facility remain constant regardless of the number of vehicles produced.
• Salaries for Administrative Staff: The company employs administrative personnel,
such as office managers, accountants, and human resources staff, to manage
day-to-day operations. These employees’ salaries constitute fixed operating costs
as they are paid a fixed amount regardless of production levels.
• Depreciation of Machinery: The manufacturing process requires specialized
machinery and equipment, such as assembly lines, robotic arms, and welding
machines. The depreciation expense associated with these assets is a fixed cost
because it represents the gradual reduction in the value of the machinery over time.
• Insurance Premiums: The company pays insurance premiums to protect its
manufacturing operations, equipment, and liability risks. These premiums are
considered fixed operating costs since they remain constant irrespective of the
production volume.
• Property Taxes: The manufacturing plant is subject to property taxes levied by local
authorities. These taxes are fixed costs as they are determined based on the assessed
value of the property and remain constant regardless of production output.

Example of Industry with High Operating Fixed Costs

Aviation Industry
The aviation industry is known for its high fixed operating costs, particularly related to aircraft
lease or purchase payments. Airlines must invest heavily in acquiring or leasing aircraft, which
involves significant upfront costs and ongoing lease payments. Additionally, the aviation
industry incurs substantial fixed costs for aircraft maintenance, fuel expenses, crew salaries,
and airport fees. These fixed costs are essential for ensuring the safe operation of flights and
maintaining compliance with regulatory requirements. Due to the capital-intensive nature
of aircraft and infrastructure, the aviation industry faces considerable financial challenges,
especially during periods of low demand or economic downturns.

6.4.4 PROFITABILITY
When assessing industries for investment, it is essential to comprehend their profitability.
Profitability is determined by a range of elements including the dynamics of demand, the
efficiency of production, the structure of costs, and the expenses related to overhead. those
that have high profit margins often demonstrate more durability and appeal to investors
in comparison to those with low margins. Profitability may be effectively analyzed using
financial ratios obtained from industry-level financial data. Notable profitability ratios
encompass the gross profit ratio, net profit ratio, operational profit ratio, return on equity
(ROE), return on investment (ROI), and return on capital employed (ROCE). Industries
with high profit margins typically earn significant profits compared to their sales, which
suggests effective cost control and strong ability to set prices. In contrast, sectors with
176
low profit margins encounter difficulties in sustaining profitability as a result of intense
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competition, narrow profit margins, and increased operational risks. Consequently, by NOTES
examining profitability ratios, investors may assess the financial well-being and long-term
viability of sectors prior to making investment choices.
It is important to understand the profitability of an industry before investing. Profits
are affected by demand, production, cost of production, overheads, etc. In order to
sustain operations in the long-run, companies must make profits. Financial ratios can
be computed to assess profitability of industries. These ratios are calculated from the
financial statements of companies–Profit and Loss Statement, Balance Sheet, Cash Flow
statement and Fund flow statement.
Some of the profitability ratios include:
• Gross Profit Ratio
• Net Profit Ratio
• Operating Profit Ratio
• Return on Equity
• Return on Investment
• Return on Capital employed

6.4.5 NATURE OF COMPETITION

It is important for investors to understand the degree of competition in an industry.
Competition is a healthy sign of growth and profitability of companies. However, too much
competition erodes the profitability of companies. The investor must analyze market
share of various companies in an industry.
Industries characterized by high or reasonable competition are widespread throughout
many sectors of the economy, each with its own distinct dynamics and problems. An example
of such an industry is the smartphone sector, which is marked by intense rivalry between
prominent brands such as Apple, Samsung, and Huawei. These firms consistently work
to create new and unique items in order to get a larger portion of the market. This leads
to a constantly changing environment where consumers have many options and benefit
from technological progress. Similarly, the fast-food business demonstrates fierce rivalry, as
global behemoths such as McDonald’s, Burger King, and KFC vie for client allegiance through
assertive marketing tactics and inventive menu offerings. Although facing competition, these
businesses have prospects for expansion and innovation, fostering ongoing enhancement
and consumer contentment. When analyzing sectors, investors should thoroughly study
aspects such as brand positioning, market share, and innovation capabilities in order to
accurately evaluate the competitive environment and determine investment potential.

6.4.6 TYPES OF INDUSTRIES

The investor must be able to find out the type of industry based on business cycles–growth,
defensive, cyclical and cyclical growth industry. Cyclical Industries moves in tandem with
economy, for example automobile industry. On the other hand, defensive industries are
not much affected by business cycles as they are necessity or luxury goods and have
inelastic demand, for example, pharmaceutical industry. The investor must understand
the nature of products, demand of products, demand scenarios in the short run, medium
run, and long run. One must also find out the major markets of the product, distribution 177
strategies among others.
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Figure 6.5: India Cement Industry Market Share in 2022
NOTES

Ultra Tech Cement

Others 30.2%
36.6%

ACC (Adani)
Dalmai Bharat
9.6%
6.7% Shree Cements
Ambuja (Adani)
8.5%
8.3%

Source: www.tradebrains.in

6.4.7 TECHNOLOGY AND RESEARCH

The use of advanced or modern technology and research and development (R&D)
paves the way for survival of industries. R& D allows companies to stay ahead of its
competition. It is through R&D that companies design new products and improve
their existing offerings. Technology is subject to frequent change. Industries that can
adapt technological changes and which spend on research and development are good
for investments.
Example: The pharmaceutical industry is highly dependent on technology and research.
Pharmaceutical businesses allocate substantial resources towards research and
development to uncover and create novel treatments, enhance current medications,
and investigate inventive treatment alternatives. The progress in technology, namely in
biotechnology and genomics, has completely transformed the procedures involved in
discovering and developing drugs. This has made it possible to create new and innovative
treatments, as well as personalized medicine. Pharmaceutical companies must consistently
engage in innovation to meet changing healthcare demands, battle illnesses, and sustain
their competitiveness in the market. Consequently, allocating funds to pharmaceutical
firms that prioritize technology and research can provide enduring opportunities for
development and resistance to obstacles within the sector.

6.4.8 GOVERNMENT POLICY

The policies of the government affect various companies in different ways. For example,
many industries enjoy tax holidays, and some are regulated by the government to protect
consumer interests. In some cases, entry barriers are placed by the government in the
interest of national security.
Example: Governmental policy influencing industry may be observed in the automobile
industry’s shift towards electric cars (EVs). Various governments throughout the globe
have enacted rules and provided incentives to encourage the use of electric vehicles
(EVs) as a means to decrease greenhouse gas emissions and address the issue of
climate change. These policies encompass financial assistance and tax benefits for
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purchasers of electric vehicles, funding for the development of charging stations, NOTES
and requirements for car manufacturers to produce a specific proportion of electric
or zero-emission vehicles. In addition, several governments have implemented more
stringent emissions rules and regulations on conventional internal combustion engine
cars in order to promote the transition to cleaner alternatives. Government initiatives
exert a significant impact on the strategies and operations of automotive companies.
These initiatives necessitate substantial investments in research and development of
electric vehicle (EV) technology, necessitate adjustments to product portfolios, and
require compliance with regulatory requirements. These measures are essential for
automotive companies to maintain competitiveness in the ever-changing automotive
market landscape.

CHECK YOUR PROGRESS – IV

Fill in the Blanks
1. Industrial growth follows a _______________________.
2. ______________________________ is the first stage in the life cycle of an industry.
3. Investment in the shares of companies in the _________________ stage leads to
erosion of capital.
4. Costs are usually divided between _________________ and __________________
costs.
5. Growth rate equals the industrial growth rate or the gross domestic product rate
during _____________________ stage.

6.5 CLASSIFICATION OF INDUSTRIES

Industries can be classified on the basis of kind of raw material used, investment in plant
and machinery, annual turnover, ownership. Moreover, industries can also be classified on
the basis of business cycle.
6.5.1 CLASSIFICATION OF INDUSTRIES ON THE BASIS OF
BUSINESS CYCLE
CYCLICAL INDUSTRIES
The growth and profitability of such industries move with the business cycle. It is during
the booming period; these industries enjoy huge growth while during a recession suffer
losses. Such industries have high revenue during periods of economic prosperity and
expansion while low revenue during periods of economic downturn and contraction.
Cyclical industries employ a variety of techniques to deal with this type of volatility.
Employee layoffs and compensation cuts during recessionary times and on the
other hand such industries pay bonus, ESOPs and hire more and more people during
expansionary phase.
During recessionary phases of economy, credit growth falls. As a result, demand falls
considerably. This is followed by a fall in production. People tend to spend less
on non-essential goods or discretionary expenses. Therefore, industries that focus on
non-essential goods face the biggest risk of revenue loss. 179
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NOTES Stock prices of cyclical companies go up during expansionary phase while stock prices
drop when the economy bottoms out. Revenues of companies badly fall and stock prices
dip. This leads to selling of stock which further puts downward pressure on the stock
prices. In the event of a longer recessionary phase, some firms even go out of business,
For example, consumer durables industry grows during periods of boom and witness
reduced sales during recessions in the economy. Similarly, airlines industry is a fairly
cyclical industry. With more disposable income, people intend to go for vacations and
make use of air travel. Conversely, during recession people are cautious in spending and
go for lesser tours and travel. Restaurants, hotel chains, furniture, high-end clothing and
fashion accessories, automobile among others are examples of cyclical industries.
As compared to cyclical industries, the defensive industries or non-cyclical industries do
not follow economic cycle. They produce and distribute essential goods as well as luxury
goods which have inelastic demand. Stocks of such companies outperform the economic
trends.
Figure 6.6: Timing to Invest in Cyclical and Defensive Sectors

Source: https://en.macromicro.me/spotlights/172/chart-one-chart-to-master-
the-timing-to-invest-in-cyclical-and-defensive-sectors

The manufacturing cycle is indicating that it has reached its lowest point and is now
beginning to recover once again. This will demonstrate how the Manufacturing Cycle
Index may aid in optimizing asset allocation through the use of an informative graphic.

I. COMPARISON BETWEEN CYCLICAL STOCKS AND DEFENSIVE STOCKS

Industry classifications, such as the Global Industry Classification Standard (GICS) created
by S&P and MSCI, are essential in determining the composition of key stock indexes.
They categorize all industries into 11 sectors: cyclical consumer, non-cyclical consumer,
financials, technology, healthcare, energy, materials, industrials, communication, utilities,
and real estate. Within these categories, there is an additional categorization that may be
made between cyclical stocks and defensive stocks:
Cyclical stocks encompass several sectors such as capital goods, transportation, financials,
180
automobile and components, technological hardware and equipment, materials,
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energy, and media. These stocks have a strong correlation with economic cycles and NOTES
are susceptible to fluctuations in value. This association emerges due to the fact that, in
times of economic prosperity, corporations thrive, resulting in higher employee earnings
and greater consumer expenditure on non-essential goods such as automobiles and
technological products. This leads to a substantial increase in industry income.
Defensive stocks encompass utilities, consumer staples, telecommunications services,
pharmaceuticals, biotechnology, and life sciences. These equities demonstrate a diminished
association with economic cycles and are less susceptible to volatility. Industries such
as energy and healthcare provide fundamental requirements regardless of economic
circumstances, guaranteeing a consistent source of income. As a result, when the economy
is experiencing a decline, these stocks show the ability to withstand the negative effects,
providing an extra level of security, which is why they are called “defensive.”

II. C
 OMPREHENDING THE VOLATILITY OF CYCLICAL AND DEFENSIVE
STOCK CYCLES
The Cyclical and Defensive Stock Ratio exhibits periodic oscillations roughly every 3-4
years, according to the industrial cycle. The duration of this economic cycle is generally
brief and is influenced by fluctuations in the demand for products, the rate of order
expansion, and the levels of inventory. The above graph has included worldwide data on
manufacturing, retail, transportation, and commerce to develop the MM Manufacturing
Cycle Index, in addition to producing PMI data for various nations. The patterns in these
indices exhibit a logical sequence.
During the first stage of the production cycle (when there is a higher level of risk), the
market expects increased demand, a high number of orders for manufacturers, and
positive profit prospects for firms. Cyclical equities, which have a strong correlation with
the economy, often exhibit positive performance (upward ratio).

Figure 6.7: Cyclical Vs Defensive Stocks

181
Source: www.investopaedia.com
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NOTES In contrast, during the declining stage of the production cycle (Risk off), the market
anticipates a decrease in demand, diminished orders for manufacturers, and negative
profit expectations for enterprises. Defensive equities, which have a lower correlation
with the overall economy, typically perform substantially better in times of economic
decline (downward ratio).
Figure 6.7 exhibits the chart showing the performance of a cyclical company, the Ford
Motor Co. (blue line) and a non-cyclical company, Florida Public Utilities Co, (yellow line).
It is clearly seen that the stock prices of Florida Public Utilities continued to rise despite
of a slowdown in the economy. However, Ford Motor Co.’s share price was affected by the
slowdown in the economy.
Thus, Cyclical Industries follow the trends of the economy thus their stock prices are
volatile.

6.6 DEFENSIVE INDUSTRIES

These industries move steadily with the economy and fall less than the average decline
of the economy. They remain unaffected by an economic recession. In other words, such
industries relatively stable or immune to economic cycle. Such industries usually deal in
necessities. Necessities as well as luxury goods have an inelastic demand i.e. with a given
change in price, there is a negligible effect on demand. The consumer will purchase the
essential items irrespective of changes in price, income, price of related goods, etc.
Following are the characteristics of defensive industries:
• They are resilient to economic fluctuations.
• They deal with necessity goods.
• They are an attractive option for investors as such industries are relatively
unaffected by market downturns.
• Stocks of such companies are stable and less volatile. This is particularly good for
investor who do not have risk appetite.
• Such non-cyclical or defensive stocks perform well in the long run.
Example of defensive industry includes food, shelter, medicines, etc. Such industries
withstand recessions.
Johnson and Johnson (J&J) are a multinational company that manufactures medical
products, pharmaceuticals and other packaged products. During the 2007–08 subprime
crisis, the Dow Jones Industrial Average fell by 53% from the end of 2007 to mid-2009 but
the stock price only dropped by 33% thus outperforming the marked by 20%.
Examples can also be seen in the Indian context. Hindustan Unilever Limited (HUL) is
an Indian fast moving consumer goods company that is headquartered in Mumbai,
Maharashtra. It is a subsidiary of Unilever, a British–Dutch company. HUL’s major products
include foods, beverages, personal care products, etc. During the 2007–08 financial crisis,
it performed well on the bourses and gained double digit growth.
Similarly, companies like GlaxoSmithKline Pharmaceuticals Ltd., manufacturer of medicines
and vaccines outperformed the market in 2007–08. During periods of volatility, investors
prefer safer avenues for investment and defensive stock are the best bet.
182 Thus, Defensive Industries are not much affected by the economic upturns and downturns.
They are relatively stable in terms of revenues and earnings.
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Amidst the COVID-19 epidemic, the healthcare sector stood out as a prime example of a NOTES
defensive business that demonstrated resilience to economic changes. Pharmaceutical,
medical device, and healthcare service companies maintained consistent demand for their
products and services despite the overall economic decline. Pharmaceutical companies
like as Pfizer and Johnson & Johnson saw consistent demand for vital treatments and
vaccinations, resulting in steady revenues and profitability throughout the crisis.
In addition, healthcare service providers, including as hospitals and clinics, continued to
operate in order to fulfil the healthcare requirements of the people, so adding to the
defensive character of the business. In light of the economic problems brought about
by the pandemic, the healthcare industry exhibited its defensive attributes by remaining
stable and operating well.

6.7 GROWTH INDUSTRIES

These industries have persistent earnings, and their growth is independent of the business
cycle. These are characterized by huge profits, high demand and massive investment.
Growth in such industries is driven by cutting edge technology, customer preferences
or lifestyle changes. Healthcare, pharmaceuticals, and virtual learning technology are
growth industry examples. Such industries are thus resilient to market fluctuations and
defies business cycle.
Software and information technology industry is a growth industry. With increasing
digitization, the market value of this industry has shot up. Similarly, pharmaceutical
industry has grown exponentially owing to rising population and increasing diseases due
to lifestyle changes.
There is another category of industries commonly called as Cyclical Growth Industries.
These industries are cyclical i.e. they perform well during periods of economic expansion
and poorly during periods of economic downturn and at the same time they are
growing. For instance, automobile industry moves with the business cycle but also grows
tremendously. New models, eye-catching colors, attractive financing schemes and better
after sales service supports automobile industry in resuming its growth trajectory.
During the late 20th and early 21st centuries in India, the software and information
technology business became a prominent example of a thriving industry. India’s IT sector seen
significant expansion due to the fast globalization and growing focus on digital transformation.
Infosys, TCS, and Wipro emerged as prominent players in software development and IT
services, propelling India’s economic growth and employment opportunities.
Moreover, the pharmaceutical sector in India saw substantial expansion over this timeframe,
driven by reasons such as the nation’s sizable population, escalating healthcare demands,
and the growing incidence of lifestyle-related illnesses. Indian pharmaceutical businesses
such as Sun Pharma, Dr. Reddy’s Laboratories, and Cipla became well-known in both local
and global markets by utilizing their knowledge in generic medications and research skills.
Conversely, the automotive sector in India serves as a prime example of a cyclical growth
industry. Although vehicle sales are subject to the effect of economic cycles, often seeing
a decline during economic downturns, the sector has shown sustained growth throughout
time. The demand for vehicles in India was driven by factors such as increasing disposable
incomes, infrastructural development, and favorable government policies. Maruti Suzuki,
Tata Motors, and Mahindra & Mahindra took advantage of these chances by launching
183
new models, appealing financing alternatives, and innovative technology to maintain
growth despite variations in the business cycle.
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NOTES These examples illustrate the varied nature of sectors in India. Some industries consistently
expand regardless of economic cycles, while others experience cyclical growth affected by
macroeconomic forces and consumer preferences.

6.7.1 CLASSIFICATION OF INDUSTRIES ON THE BASIS OF

RAW MATERIAL
• Agro-based Industries: Industries that use plant and animal-based products as
their raw material. Examples include vegetable oil, cotton textile, etc.
• Forest-based Industries: These industries uses raw material from forests like wood.
Examples include paper, furniture, etc.
• Marine-based Industries: These industries use raw materials from water bodies
like ocean. Examples include food industry, oil industry, etc.
• Mineral-based Industries: They are based on minerals mined from the earth.
Industries include steel and iron industry as well as heavy machinery industries.

6.7.2 CLASSIFICATION OF INDUSTRIES ON THE BASIS OF INVESTMENT

IN PLANT AND MACHINERY ALONG WITH ANNUAL TURNOVER
(revised classification applicable w.e.f. 1st July 2020)

Table 6.1: Classification of industries based on investment in plant

and machinery along with annual turnover

Classification Micro Small Medium Large

Investment Not more than Not more than Not more than Above Rs. 50
in Plant and Rs. 1 crore Rs. 10 crore Rs. 50 crore crore
Machinery
Annual Turnover Not more than Not more than Not more than Above Rs. 250
Rs. 5 crore Rs. 50 crore Rs. 250 crore crore
Source: https://msme.gov.in/know-about-msme

6.7.3 CLASSIFICATION OF INDUSTRIES ON THE BASIS OF

OWNERSHIP
• Private Sector: These that are not state-controlled and is run by individuals and
companies for profit.
• Public Sector: These are owned and managed by the government. For example,
BHEL, Coal India Ltd, EIL, etc.
• Joint Sector: These are jointly owned by the government and private entities. For
example, Oil India Ltd (OIL), Bharat Petroleum Corporation Limited (BPCL), etc.
• Cooperative: They are run and controlled by a group of individuals. The members
are the ones who produce raw materials. Examples include dairy products, food
processing, etc. Amul is a classic model of cooperative.
Industry analysis is essential for investment research and valuation because it offers
184 significant insights into the dynamics and trends that influence various sectors of the
economy. Investors may make well-informed judgements about asset allocation, portfolio
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diversification, and stock selection by comprehending the traits, competitive environment, NOTES
and development potential of different industries. Furthermore, industrial research
enables investors to discern possibilities and hazards linked to certain industries.

CASE STUDY
The country’s largest manufacturer of motorcycles and scooters, Hero MotoCorp
recorded its highest-ever festive sales in 2023 clocking more than 14 lakh units in retail
sales during the 32-day festive period, between the first day of the Navratri and Bhai
Dooj.
Riding on robust demand across rural markets as well as steady retail off-take in key
urban centers, the company has registered 19 per cent growth over the previous year,
and surpassed its previous highest retail of 12.7 lakh units recorded in the 2019 festive
period.
The strong portfolio of brands, distribution scale and new launches have driven growth
across geographies. The festive season is a clear testimony that rural sector is coming
back to growth, which augurs well for the country, in general, and the two-wheeler
industry in particular.
Adding cheer to the festive season, Hero MotoCorp rolled out the second edition of
Hero GIFT-the Grand Indian Festival of Trust–its leading programme targeted specifically
for the festive period-encompassing new model refreshes, eye-catching color schemes,
exciting benefits and attractive finance schemes for customers.
As part of the mega campaign-with Iss Tyohar, Nayi Raftaar as its theme–customers
availed a big range of motorcycles and scooters, with attractive finance schemes and
low interest rates. The record retail number was achieved due to strong customer
traction across markets, with double-digit growth in the Central, North, South and East
zones. Robust customer demand in the rural markets, in addition to positive sentiment
in key urban centers, drove the record retail sales. With this, the post-festive channel
inventory has dropped to its lowest level in more than three years. This has set Hero
Moto Corps on a steady growth path for the rest of the fiscal year.
All the four major two wheeler companies have clocked a big growth in annual
deliveries—Hero, Honda, TVS and Bajaj Auto. There was record demand for Royal Enfield
bikes as well.
The 2W category thus saw several positive trends, buoyed by festive cheer and stronger
rural demand.
Prepare a SWOT matrix of Hero Moto Corps. Can you evaluate the competitiveness of
this company using the Porter’s Five Forces Model?
Business Line/16 November, 2023
Source: www.tradebrains.in

CHECK YOUR PROGRESS – V

Tick the right answer:
185
1. Investing in non-cyclical stocks is considered to be safer than investing in cyclical
stocks. (True/False)
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Industry Analysis
NOTES 2. Healthcare products, fuels, utilities and consumer staple goods are cyclical stocks.
(True/False)
3. Companies with investment in plant and machinery of not more than 50 crore are
considered as large companies. (True/False)
4. Companies manufacturing necessities come under the category of cyclical industries.
(True/False)

6.8 LET US SUM UP

• The concept of Industry analysis is one of the components of fundamental analysis.
• The concept of industry and classified industries is based on the usage of raw material,
investment in plant and machinery, annual turnover and of business cycle.
• Industries are classified into cyclical, defensive, growth and cyclical growth industry on
the basis of business cycle.
• According to the concept of industry life cycle, industries usually move through four
well defined stages–pioneering stage, rapid growth stage, maturity and stabilization
stage and declining stage.
• Apart from industry life cycle stages, investment in a particular industry also depends
upon a host of other factors like cost structure and profitability, nature of the product,
nature of the competition and research and development among others.
• The most prominent techniques to analyze industries include – SWOT matrix, Porter’s five
forces model, product-demand analysis, and input-output analysis. These techniques are
significant as they help an investor in carrying out industry analysis.

6.9 KEYWORDS
Industry Analysis: Assessing industries for their overall performance and growth and
thereby deciding whether to invest in a particular industry.
Cyclical Industries: Growth of such industries move with the business cycle.
Defensive Industries: Industries which are immune to business or economic cycles. They
remain unaffected by economic recession.
Growth Industries: They are independent of business cycle. They are characterized by
huge profits, high demand, and massive investment.
Cyclical growth Industries: They perform well during period of economic expansion and
poorly during periods of economic downturn but at the same time they are growing.

6.10 SELF-ASSESSMENT QUESTIONS

Multiple Choice Questions
1. What was the concept given by Julius Grodensky?
(a) Business cycle
(b) Industry Life cycle
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(c) Five forces model NOTES
(d) SWOT matrix
2. Mr. X is a young investor who dares to take risks. He wants to increase the return of
his portfolio. What kind of industry should he invest in?
(a) Defensive Industry
(b) Cyclical Industry
(c) Cyclical growth Industry
(d) Growth Industry
3. What kind of industry is consumer durables industry?
(a) Defensive
(b) Growth
(c) Cyclical
(d) None of the above
4. Intense competition and survival of the fittest is associated with which stage of the
industry life cycle?
(a) Pioneering stage
(b) Growth stage
(c) Maturity and stabilization stage
(d) Declining stage
5. Which among the following is not a part of Porter’s five forces model?
(a) Bargaining power of the suppliers
(b) Bargaining power of the competitors
(c) Bargaining power of the buyers
(d) All of the above
6. What type of technique of industry analysis explains the factors behind the demand
for output of a certain industry?
(a) SWOT Matix
(b) ETOP
(c) Product-demand analysis
(d) Input-Output Analysis
7. When is the bargaining power of suppliers high?
(a) Number of suppliers is high.
(b) Number of suppliers is low.

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NOTES (c) Number of buyers is high.
(d) Number of buyers is low.
8. Which stage in the industry life cycle is termed as the “stage of lateral obsolescence”?
(a) Pioneering stage
(b) Rapid growth stage
(c) Maturity and Stabilization stage
(d) Declining Stage

6.11 REFERENCES AND SUGGESTED ADDITIONAL READINGS

1. Fischer, D.E. and Jordan, RJ, Security Analysis and Portfolio Management, Sixth
edition, PHI
2. Kevin, S., Security Analysis and Portfolio Management, Third Edition, PHI

6.12 CHECK YOUR PROGRESS — POSSIBLE ANSWERS

Check Your Progress – I
1. True
2. True
3. True
4. False
Check Your Progress – II
1. False
2. False
3. True
4. False
Check Your Progress – III
1. (c)
2. (b)
3. (c)
4. False
5. False
Check Your Progress – IV
1. Cyclical
2. Pioneering
3. Decline
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4. Variable Costs, Fixed Costs NOTES
5. Maturity
Check Your Progress – V
1. True
2. True
3. False
4. False

6.13 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (b) 2. (d) 3. (c) 4. (a)
5. (b) 6. (c) 7. (b) 8. (c)

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STRUCTURE
7.0 Objectives
7.1 Introduction to Company Analysis
7.2 Management
7.3 SWOT Analysis
7.4 Competitive Advantage
7.5 Business Risk Analysis
7.6 Financial Risk Analysis
7.7 Finding Intrinsic Worth of a Share
7.8 Let Us Sum Up
7.9 Keywords
7.10 References and Suggested Additional Reading
7.11 Self-Assessment Questions
7.12 Check Your Progress – Possible Answers
7.13 Answers to Self-Assessment Questions

7.0 OBJECTIVES
After reading this unit, you will be able to:
1. recognize the significance of conducting thorough company analysis as a
foundation for informed investment decisions.
2. assess the role of management in a company’s success and growth, and
understand the key factors that contribute to effective leadership.
3. conduct a SWOT analysis to systematically identify a company’s internal strengths
and weaknesses, as well as external opportunities and threats.
4. evaluate different types of business risks, including industry-specific risks,
operational risks, and regulatory risks, to gauge their potential impact on a
company’s performance.
5. understand financial risk analysis by studying factors like leverage, liquidity,
solvency, and financial stability, and their implications for investment
decision-making. 191
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NOTES RECAP OF UNIT 6

In the previous unit, we have learnt that Industry Analysis provides a comprehensive view
of a business within the industry segment. It starts with an introduction, progressing to the
renowned Porter’s 5 Forces Model that evaluates market competition. The Industry Life
Cycle concept examines stages from inception to maturity. Cyclical Industries are explored
that are influenced by economic fluctuations. The Defensive Industries remain stable in
adversity. Conversely, Growth Industries exhibit promising potentials for growth. This analysis
unveils different dynamics contributing to industries growth, business strategies, planning,
risk assessment and growth projection. This facilitates fostering informed decisions that align
with market trends and competitive forces.

7.1 INTRODUCTION TO COMPANY ANALYSIS

Company analysis involves assessing a company’s financial and operational performance
to identify its strengths, weaknesses, opportunities, and threats, similar to structural
analysis. This research assists investors, financial analysts, and other stakeholders in
making well-informed decisions regarding the organisation.
Various facets of a corporation can be examined, such as:
1. Financial Performance: Financial performance assessment involves analysing
a company’s revenue, profitability, cash flow, and financial metrics including
debt-to-equity ratio, return on equity, and current ratio. This analysis provides
insights into the company’s financial health and its ability to generate profits
and manage its resources effectively, thus informing investment decisions and
strategic planning.
2. Competitive Positioning: Competitive positioning entails evaluating a company’s
market share, its rivals, and its capacity to compete within the industry.
Understanding the competitive landscape helps in identifying the company’s
strengths and weaknesses relative to its peers, enabling strategic positioning to
capture market opportunities and mitigate threats.
3. Management Team: This involves assessing the leadership team’s past
performance, expertise, and capacity to implement the company’s plan.
A competent management team with a track record of success can inspire
investor confidence, drive innovation, and navigate challenges effectively,
contributing to the company’s long-term success and sustainability.
4. Industry Trends: Industry trends encompass comprehending technology
improvements, regulatory changes, and consumer behavior within the company’s
operating business. Keeping abreast of industry trends allows companies to
anticipate shifts in the market, identify emerging opportunities, and adapt their
strategies accordingly to stay competitive and relevant in a dynamic business
environment.
5. Growth Potential: Evaluating the company’s capacity for development, which
includes its expansion strategies, introduction of new products, and potential for
market expansion. Assessing growth potential helps investors and stakeholders
gauge the company’s future prospects and assess its ability to generate value
192 over the long term, driving investment decisions and strategic planning.
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6. Corporate Governance: Corporate governance involves assessing the company’s NOTES
board of directors, CEO remuneration, and shareholder rights. Strong corporate
governance practices promote transparency, accountability, and ethical conduct,
fostering investor trust and confidence in the company’s management and
operations, ultimately enhancing long-term shareholder value and organizational
sustainability.

For example, Johnson & Johnson (J&J) demonstrates effective corporate governance
practices through its autonomous board of directors, comprehensive code of ethics
emphasizing honesty, proactive involvement with shareholders, equitable executive
remuneration linked to long-term shareholder value generation, and rigorous risk
management procedures. J&J maintains impartial monitoring by having a majority
of independent directors, and it supports ethical standards and compliance through
its thorough code of conduct. The company’s initiatives to communicate with shareholders
promote openness and accountability, while its methods for compensating executives are
intended to motivate performance that aligns with shareholder interests. In addition,
J&J’s approach to proactive risk management highlights its commitment to responsible
business practices, further strengthening its position as a recognized leader in the global
healthcare industry.

CHECK YOUR PROGRESS – I

1. What financial aspects are typically analyzed in a company’s performance

assessment?
(a) Assessing consumer behavior
(b) Analyzing market share
(c) Reviewing debt-to-equity ratio
(d) Evaluating technological improvements
2. What does competitive positioning involve in company analysis?
(a) Assessing CEO remuneration
(b) Analyzing revenue growth
(c) Evaluating market share and industry competition
(d) Understanding board of directors’ performance
3. Why is it important to assess the management team in company analysis?
(a) To determine market trends
(b) To understand financial ratios
(c) To identify growth potential
(d) To evaluate leadership capability
4. What does industry trends encompass in company analysis?
(a) Assessing board of directors
193
(b) Understanding technology improvements
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NOTES (c) Analyzing debt-to-equity ratio

(d) Reviewing cash flow patterns
5. How is growth potential typically evaluated in company analysis?
(a) Assessing competitive positioning
(b) Analyzing CEO remuneration
(c) Reviewing industry trends
(d) Evaluating expansion strategies

7.2 MANAGEMENT
Management is essential in analyzing and valuing a company, since the skill and efficiency
of the management team have a substantial influence on the firm’s performance, growth,
and total worth. Here are crucial elements of management within the framework of firm
analysis and valuation:
• Leadership and Vision: The success of senior management is frequently
demonstrated by their leadership skills and strategic foresight. Effective executives
establish the company’s course, establish overarching objectives, and motivate the
whole organisation.
• Execution Capabilities: Having a strategic vision is important, but being able to
effectively carry out plans is just as vital. Analysts evaluate the management team’s
ability to convert strategic objectives into measurable outcomes, such as increased
revenue, efficient cost control, or market enlargement.
• Financial Stewardship: Responsible handling of finances is a crucial factor. Analysts
assess the management team’s effectiveness in resource allocation, budget
management, and financial discipline. This involves making wise choices about
how to allocate resources and effectively managing working capital.
• Track Record and Experience: The track record and experience of a management
team are crucial indicators of their capability to handle obstacles and take
advantage of opportunities. Examining past performance, especially in times of
economic decline or industry changes, offers valuable information about their
ability to make decisions.
• Communication Skills: It is essential to communicate effectively with stakeholders,
including as shareholders, analysts, and workers. Open and honest communication
fosters trust and provides stakeholders with an accurate view of the company’s
opportunities and obstacles.
• Corporate Governance: Strong corporate governance signifies a dedication to
ethical behavior, responsibility, and safeguarding shareholders’ interests. Analysts
examine the board’s membership, independence, and governance measures to
prevent conflicts of interest.
• Succession Planning: A well-run organisation prepares for leadership transitions.
Analysts evaluate if the organisation has a well-defined succession plan to facilitate
a seamless transition in the event of significant leadership changes.
• Adaptability and Innovation: Adaptability and innovation are crucial in a changing
194 corporate environment. Management’s capacity to predict business trends, adopt
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technical progress, and cultivate an innovative culture is crucial for a company’s NOTES
enduring prosperity.

Example: Apple Inc. is famous for its robust management team, headed by CEO Tim
Cook, who is highly regarded for his strategic foresight and operational proficiency.
Under Cook’s leadership, there has been notable progress in terms of innovation, the
introduction of successful products, and consistent financial expansion. Apple has
successfully upheld a unified and skilled executive team under his guidance, which includes
notable executives such as Chief Design Officer Jony Ive and Chief Operating Officer Jeff
Williams. These individuals are recognized for their significant contributions in the areas
of product design and supply chain management, respectively. The company’s regular
delivery of revolutionary products, including Apple the iPhone and iPad, demonstrates
the efficiency of its management in fostering innovation and retaining market dominance.
Likewise, Microsoft, led by CEO Satya Nadella, has seen a significant change, with a
strong emphasis on cloud computing and services. Nadella’s leadership approach, which
prioritizes empathy, collaboration, and innovation, has reinvigorated Microsoft’s culture
and propelled its expansion in the cloud computing sector. Microsoft has effectively
managed technical advancements and maintained its leadership in the IT industry with its
skilled and diversified management staff.

CHECK YOUR PROGRESS – II

1. The success of senior management is often demonstrated by their _______________

skills and strategic foresight.
2. Analysts evaluate the management team’s ability to convert strategic objectives
into measurable outcomes, such as increased ____________, efficient cost control,
or market enlargement.
3. Analysts assess the management team’s effectiveness in resource allocation, budget
management, and financial discipline. This involves making wise choices about how
to allocate resources and effectively managing ______________.
4. Examining past performance, especially in times of economic decline or industry
changes, offers valuable information about their ability to make ____________.
5. Open and honest communication fosters trust and provides stakeholders with an
accurate view of the company’s opportunities and ____________.

7.3 SWOT ANALYSIS

Figure 7.1: SWOT Analysis

Strength Weaknesses

SWOT

Oppotunities Threats

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NOTES When a company aims to assess its overall effectiveness, it may employ a SWOT analysis,
identifying strengths, weaknesses, opportunities, and threats through an objective
approach. The application of this method can assist a company in optimizing its operations
and excelling within its industry.
A SWOT analysis is a technique that assesses strengths, weaknesses, opportunities,
and threats. Many professionals utilize this framework to evaluate entire companies,
determining the sustainability of their current operations over the long term.
However, it is also applicable to individual departments or projects to assess their
viability. The strengths and weaknesses sections pinpoint internal components affecting
a company, such as intellectual property, location, and employees. Meanwhile, the
opportunities and threats concentrate on external factors like the cost of raw materials
and consumer buying trends.
Let us understand this concept in detail.

STRENGTHS
Identifying a company’s core competencies is crucial for recognizing unique capabilities
and resources that provide a competitive advantage in the market. A strong brand
reputation signifies the perceived strength of the brand and its standing among
consumers. Operational efficiency is a key factor, assessing how well the company
manages its processes and allocates resources for optimal performance. The skilled
workforce contributes significantly, and evaluating the expertise and skills of employees
is vital for success. A company’s competitive edge lies in understanding and leveraging
its core competencies, reinforcing its brand reputation, and maintaining operational
efficiency. The perception of the brand in the market impacts consumer trust and
loyalty. Efficient management of processes ensures resource optimization and cost-
effectiveness. A skilled workforce enhances productivity and innovation. The interplay of
these strengths forms the foundation for a company’s success and sustainability in the
competitive business landscape.

WEAKNESSES
Analyzing operational challenges is essential, focusing on areas where the company may
be inefficient or encountering difficulties in its processes. Evaluating financial constraints
involves identifying weaknesses in the financial structure, such as high debt levels or low
liquidity, which can impact the company’s stability. Assessing the product portfolio is
crucial to determine if the company relies too heavily on a narrow range of products or
services, potentially limiting its market reach. Identifying management issues is important,
addressing leadership or governance challenges that may hinder overall performance and
decision-making. Operational inefficiencies can hinder the company’s effectiveness, and
financial weaknesses may pose risks to its stability. Overreliance on a limited product range
could impact market competitiveness. Effective management and governance are crucial
for overcoming weaknesses and ensuring sustained growth. Addressing these internal
challenges is key to enhancing the company’s overall resilience and success in the market.

OPPORTUNITIES
Opportunities stem from external variables that a firm might utilise to achieve
196 development and success. Examining market trends is essential, with a focus on new
developments and evolving customer preferences that the organisation may leverage for
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strategic advantage. Exploring technology breakthroughs offers possibilities to embrace NOTES
creative solutions and remain competitive in the industry. Evaluating market growth
entails assessing the possibility of entering new markets or extending current ones to
reach previously unexplored client segments. It is crucial to consider strategic alliances
since they may provide synergies, improve capabilities, and provide new opportunities for
the organisation. Recognising and capitalizing on these external possibilities is crucial for
the company’s strategic growth and long-term viability.

THREATS
Threats come from external sources that present difficulties and threats to a company’s
stability. Studying market competition is crucial for identifying possible threats from
competitors and sustaining a competitive advantage in the sector. It is essential to
anticipate regulatory changes due to the potential influence of modifications in laws
and regulations on corporate operations. Identifying weaknesses that might be exposed
during economic contractions allows the firm to ready itself for financial difficulties in
harsh economic climates. Recognising new rivals is essential to be alert against potential
disruptors that might jeopardize the company’s market position. It is crucial to handle
these external dangers in advance to strategically plan and ensure the company’s resilience
in a constantly changing business environment.

7.3.1 EXAMPLE
SWOT ANALYSIS OF TESLA, INC.
STRENGTHS
• Innovative technology: Tesla is known for its cutting-edge electric vehicle technology,
including advanced battery systems and autonomous driving features.
• Strong brand image: Tesla has established itself as a leader in the electric vehicle
market, renowned for its commitment to sustainability and innovation.
• Vertical integration: Tesla controls its entire supply chain, from battery production
to vehicle assembly, allowing for greater control over quality and costs.
• Growing market share: Despite competition, Tesla continues to expand its market
share in the electric vehicle industry, with increasing sales worldwide.
• Renewable energy solutions: Beyond electric vehicles, Tesla also offers solar
energy products and energy storage solutions, diversifying its revenue streams.

WEAKNESSES
• Production challenges: Tesla has faced production bottlenecks and delays in
meeting demand for its vehicles, impacting revenue and customer satisfaction.
• High production costs: The cost of manufacturing electric vehicles remains
relatively high compared to traditional gasoline-powered vehicles, affecting
profitability.
• Dependence on government incentives: Tesla’s sales are influenced by government
subsidies and incentives for electric vehicles, making it vulnerable to changes in
policy.
• Limited vehicle models: Tesla’s product lineup is relatively small compared to 197
traditional automakers, potentially limiting its market reach and customer base.
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NOTES • Quality control issues: Some Tesla vehicles have faced quality control issues and
recalls, affecting brand reputation and customer trust.

OPPORTUNITIES
• Expansion into new markets: Tesla has opportunities to enter emerging markets
and regions with growing demand for electric vehicles, such as Asia and Europe.
• Technological advancements: Continued investment in research and development
can lead to breakthroughs in battery technology and autonomous driving
capabilities, further enhancing Tesla’s competitive edge.
• Diversification of product portfolio: Tesla can explore diversifying its product
portfolio beyond electric vehicles, such as expanding its energy storage and solar
business.
• Partnerships and collaborations: Forming strategic partnerships with other
companies or automakers can provide opportunities for technology sharing and
market expansion.
• Sustainable energy initiatives: Increasing focus on sustainability and renewable
energy solutions presents opportunities for Tesla to align with global environmental
trends and consumer preferences.

THREATS
• Intense competition: Tesla faces competition from traditional automakers and
new entrants in the electric vehicle market, increasing pressure on market share
and pricing.
• Regulatory challenges: Changes in government regulations and emissions
standards can impact Tesla’s operations and sales, particularly in key markets.
• Supply chain disruptions: Dependencies on suppliers for components and raw
materials expose Tesla to risks of supply chain disruptions, affecting production
and delivery timelines.
• Economic downturns: Economic uncertainties and recessions can reduce
consumer spending on luxury goods like electric vehicles, impacting Tesla’s sales
and revenue.
• Legal and safety concerns: Tesla faces potential legal and safety challenges related
to product defects, accidents involving autonomous driving features, and regulatory
compliance issues, which could lead to lawsuits and reputational damage.

This SWOT analysis highlights Tesla’s strengths in technology innovation and brand
recognition, as well as its weaknesses in production challenges and quality control issues.
Opportunities lie in market expansion and technological advancements, while threats
include competition, regulatory challenges, and supply chain disruptions.

7.3.2 WHAT IS THE SIGNIFICANCE OF SWOT ANALYSIS?

SWOT Analysis may assist in questioning unsafe assumptions and revealing critical blind
spots about the organization’s performance. When used meticulously and cooperatively,
it may provide fresh perspectives on the business’s present status and assist in crafting the
198 most suitable plan for each scenario.
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For instance, some of the organization’s strengths may be recognized, but without NOTES
documenting them along with weaknesses and threats, true reliability of those strengths
may not fully be comprehended.
Similarly, there may be valid worries about certain shortcomings in the organization.
However, by conducting a methodical examination, an opportunity may be discovered
that was previously ignored, which might more than make up for those deficiencies.

CHECK YOUR PROGRESS – III

1. Identifying a company’s core competencies is crucial for recognizing unique
capabilities and resources that provide a competitive advantage in the market.
These core competencies give the company its distinct _______ in the industry.
2. A strong brand reputation signifies the perceived strength of the brand and its
standing among consumers. It is built on consistent delivery of _______ and meeting
customer expectations.
3. Operational efficiency is a key factor, assessing how well the company manages its
processes and allocates resources for optimal performance. It ensures _______ and
reduces wastage.
4. The skilled workforce contributes significantly, and evaluating the expertise and
skills of employees is vital for success. A company’s competitive edge lies in _______
the right talent and fostering a culture of continuous learning and development.
5. The interplay of these strengths forms the foundation for a company’s success and
sustainability in the competitive business landscape, enabling it to _______ and
adapt to changing market dynamics.

7.4 COMPETITIVE ADVANTAGE

Competitive advantage is the distinctive qualities and capabilities that enable a company
to surpass its competitors and attain exceptional success in the market. Company analysis
is crucial since it immediately impacts a company’s capacity to succeed in a competitive
business landscape.
Cost leadership is a crucial element of competitive advantage. Cost leadership may be
attained by effectively managing resources, optimizing manufacturing processes, and
capitalizing on economies of scale. This enables the firm to provide products or services
at a reduced cost compared to its competitors, attracting price-sensitive clients and
achieving a competitive advantage.
Differentiation is another aspect of competitive advantage. Businesses may distinguish
themselves by providing distinctive and high-quality products, innovative characteristics,
or great customer service. Distinguishing characteristics provide a perceived worth in the
eyes of customers, resulting in client loyalty and the implementation of a premium pricing
approach. This competitive advantage is durable if buyers see the unique qualities as
desirable and challenging for competitors to imitate.
Moreover, organizations can get a competitive edge by implementing a focus strategy
that targets a certain market segment or niche. A corporation can get a competitive edge
through specialization by customizing products or services to cater to the specific demands
of a certain consumer group, fostering strong connections within that segment. 199
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NOTES Competitive advantage in company analysis is comprehending a firm’s market positioning

strategy, which may incorporate cost leadership, differentiation, or focus. Companies may
boost their market position, profitability, and competitive advantage by recognising and
utilizing these benefits.
Competitive advantage pertains to elements that enable a company to manufacture
goods or services more effectively or at a lower cost than its competitors. These elements
enable the producing organisation to achieve more sales or better profits than its
competitors in the market. Competitive advantages stem from elements such as cost
structure, branding, product quality, distribution network, intellectual property, and
customer service.
Competitive advantages provide more value for a company and its shareholders due to
certain strengths or circumstances. A competitive advantage that is more sustainable
is harder for competitors to neutralize. There are two primary forms of competitive
advantages: comparative advantage and differentiated advantage.
Comparative advantage occurs when a company can manufacture goods more effectively
and at a reduced expense compared to its rivals.
A differential advantage occurs when a company’s products or services are perceived as
superior than those of its rivals due to their unique characteristics. Cutting-edge technology,
patented goods or processes, skilled individuals, and a strong brand identification all
contribute to a differentiated advantage. These characteristics contribute to substantial
profit margins and significant market dominance.
Example: Apple is renowned for developing cutting-edge products like the iPhone and
maintaining its dominant position in the market through strategic marketing efforts to establish
a premium brand. Another instance involves prominent pharmaceutical corporations.
Branded medications can be sold at premium prices due to patent protection.

7.4.1 BUILDING A COMPETITIVE ADVANTAGE

A company can establish a competitive edge through one of three primary approaches.
• Cost: Offer products at the most competitive pricing
• Differentiation: Offer products or services that excel in quality, service, or
characteristics
• Specialization: Offer products or services specifically designed for a targeted
market.

Competing based on price can be successful, but excessive price reductions may lead to
unsustainable profit margins. Many companies choose to distinguish themselves in other
methods, which aids in maintaining or increasing their profit margin.

7.4.1.1 ADVANTAGES OF A COMPETITIVE EDGE

When a firm establishes a lasting competitive advantage, it distinguishes itself from
competitors and delivers value to consumers and stakeholders. The corporation
may increase sales, income, and profits by creating a superior product or service that
outperforms its competitors.
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7.4.1.2 D EVELOPING STRATEGIES TO ESTABLISH A NOTES
COMPETITIVE EDGE
In order to establish a competitive edge, a firm must identify its unique qualities compared
to its competitors and tailor its message, service, and goods accordingly. Here are many
tactics organizations employ to establish a competitive edge:
• Market Research: Conduct market research to discover and define the target
market, which can assist in establishing a competitive edge.
• Identify strengths: A corporation may determine its distinctive advantages compared
to rivals by evaluating goods, services, features, positioning, and branding.
• Assess financial situation: Businesses can analyze their financial performance
by examining financial statements and ratios to identify profitable segments and
stable areas.
• Operations review: What is the level of efficiency in a company’s operations?
Where does it work well and where might it be enhanced? Take into account
customer service, manufacturing, and supply chain management.
• Reflect on human resources: The caliber of talent a firm can recruit for both
workers and leadership roles significantly impacts the performance of the
organisation. Assessing corporate culture, recruitment, and personnel procedures
might be beneficial.

CHECK YOUR PROGRESS – IV

1. Competitive advantage involves distinctive qualities and capabilities that hinder a
company from surpassing its competitors in the market.
(a) True
(b) false
2. Cost leadership in competitive advantage can be achieved by effectively managing
resources, optimizing manufacturing processes, and capitalizing on economies of
scale.
(a) True
(b) false
3. Distinguishing characteristics in differentiation provide a perceived worth in the
eyes of customers, resulting in client loyalty and the implementation of a premium
pricing approach.
(a) True
(b) false
4. Differentiation involves providing generic and low-quality products to attract a wide
customer base.
(a) True
(b) false
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NOTES 5. A focus strategy that targets a certain market segment or niche can provide a
competitive edge through specialization by customizing products or services to
cater to the specific demands of a broad consumer group.
(a) True
(b) false

7.5 BUSINESS RISK ANALYSIS

Business decisions may optimize earnings and facilitate growth, although leaders must
also consider the dangers associated with their actions. Conducting a risk analysis is
crucial for detecting possible dangers in a company choice that may impact profitability,
productivity, or harm customer relations.
Business risk analysis is evaluating elements that might affect a company’s capacity to
reach its financial goals and objectives. Key elements of company risk analysis include
revenue volatility and operational leverage.
Revenue volatility is the extent of variation in a company’s sales or profits throughout a
certain timeframe. High revenue volatility poses a substantial company risk by causing
unexpected cash flows and financial instability. Several variables contribute to revenue
volatility, including fluctuations in customer demand, market competitiveness, economic
conditions, and external shocks.
Businesses in sectors characterised by cyclical demand, like technology or automotive,
could encounter increased revenue fluctuations. Businesses frequently use tactics like
diversifying product offerings, entering new markets, or introducing flexible pricing
systems to analyze and manage risk. Companies seek to enhance financial stability and
predictability by comprehending and reducing revenue fluctuations.
Operating leverage is the extent to which a company’s fixed operating costs impact its
total cost structure. High operating leverage indicates that a considerable amount of a
company’s expenses are fixed, causing a minor sales adjustment to have a larger effect on
earnings. High operating leverage can boost profits when sales grow but also raises the
danger of substantial profit drops when sales plummet.
Businesses that have significant fixed expenses, including industrial facilities,
infrastructure developments, or sectors requiring substantial capital investment,
typically have more operational leverage. Companies can mitigate this risk by using
tactics such as cost control measures, optimizing capacity utilisation, and diversifying
income streams. Companies aim to combine the possibility for higher profitability with
financial stability during economic downturns by meticulously evaluating and modifying
their operating leverage.
Case Study: XYZ Corporation, a prominent producer in the electronic gadgets sector,
conducted an in-depth business risk assessment centered on revenue fluctuation and
fixed operating expenses, resulting in significant operating leverage. The investigation
uncovered the complexities of the company’s vulnerability to market swings and how it
may affect financial stability.
The market trends show a quickly changing environment, with consumers favoring new
features and technical progress. The dynamic environment led to revenue fluctuations as
202
XYZ Corporation found it challenging to anticipate and adjust to shifting market needs.
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The research emphasized the company’s fixed operational expenses, which involve NOTES
significant expenditures in advanced production facilities and a qualified crew.
These expenditures elevated XYZ Corporation to an industry leader status but also brought
in a substantial amount of operating leverage.
Fixed operational expenses resulted in excellent profit margins during times of strong sales.
Yet, the drawback became apparent during economic downturns or market contractions,
exacerbating the adverse effect on profitability because of the inflexible character of fixed
expenses.
The risk analysis highlighted the necessity for XYZ Corporation to adopt strategic initiatives
to reduce these difficulties. This involved expanding product offers to match new market
trends, strengthening supply chain durability, and enforcing cost-cutting strategies during
times of reduced income.
Ultimately, the business risk study highlighted the important relationship among revenue
volatility, fixed operating costs, and operational leverage for XYZ Corporation. The firm
sought to strengthen its financial resilience, sustain a competitive advantage, and
traverse the volatile electronic devices market by comprehending and dealing with these
characteristics.
Interpretation: XYZ Corporation’s business risk analysis highlights the intricate
relationship between revenue fluctuations and fixed operating expenses, resulting in
significant operational leverage. In the fast-changing electronic devices business, the
corporation must adapt its product offerings to match shifting consumer tastes and
unforeseen market trends. XYZ Corporation has become an industry leader due to
significant expenditures in advanced production facilities and a talented personnel.
However, the company’s fixed operating costs make it more financially vulnerable during
economic downturns. The analysis highlights the importance for XYZ Corporation to
implement strategic actions like diversification and cost management to address the
difficulties of revenue volatility and operational leverage, in order to maintain profitability
and resilience in a competitive market.

7.6 FINANCIAL RISK ANALYSIS

Financial risk refers to the potential of experiencing financial loss in an investment or
commercial endeavor. Common financial hazards include credit risk, liquidity risk, and
operational risk.
Financial risk is a potential threat that may lead to the depletion of money for stakeholders.
Governments may lose the ability to regulate monetary policy and may default on bonds
or other financial obligations. Corporations may default on debt and can encounter
financial burdens due to failed undertakings.
Financial risk analysis is an in-depth analysis of an organization’s vulnerability to
uncertainties associated with its financial framework and commitments. Fixed
financial costs and significant financial leverage might affect the company’s financial
well-being.
Fixed financial costs are non-variable expenses that a corporation incurs regardless of its
production or sales volume. The costs encompass interest on loans, lease payments, and
other contractual responsibilities. High financial leverage suggests a substantial dependence
203
on debt to fund operations, increasing the effect of fixed financial expenses.
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NOTES The organisation is at a higher financial risk since it relies heavily on borrowed funding.
Financial leverage may increase profits in prosperous times but also increases susceptibility
to economic downturns or unforeseen disasters. A decrease in earnings may provide
challenges in fulfilling fixed financial commitments, sometimes leading to financial
hardship.
Conducting a thorough financial risk analysis includes assessing the company’s debt
composition, interest coverage ratios, and general financial well-being. Strategies are
required to reduce risks, including refinancing debt, optimizing the capital structure, and
balancing equity and debt funding. A corporation may improve its resilience and make
well-informed financial decisions in a changing business environment by comprehending
and controlling fixed financial expenses and financial leverage.
It can encompass these five primary categories of risk:
1. Market risk pertains to the dynamic business environment and its impact on
corporate operations. Market risk examples include the impact of online
purchasing on traditional retail firms and the influence of the internet on print
publications.
2. Credit risk arises from providing credit to a client who fails to make payments.
This might cause a disturbance in the cash flow and diminish the earnings.
3. Liquidity risk is the potential for a corporation to be unable to rapidly convert
its assets into cash in the event of an immediate need for cash. It also denotes a
company’s failure to fulfil its financial commitments.
4. Operational risk is the possibility that operational breakdowns, such as
mismanagement, fraud, business model failure, or technical challenges, may
impact the firm’s performance.
5. Currency risk refers to the potential for adverse fluctuations in the exchange rate
between the primary currency and the currency used in a specific transaction.
Businesses that have diversified into overseas markets or significantly rely on
importing and exporting commodities are the most vulnerable.

7.7 FINDING INTRINSIC WORTH OF A SHARE

Intrinsic value refers to the inherent worth of a stock or enterprise, regardless of external
causes. Financial experts create models to calculate the intrinsic value of a company’s
shares, which is different from its market price.
The difference between the market price and an analyst’s calculated intrinsic value serves
as an indicator of investment potential. Individuals who see these models as accurate
evaluations of inherent value and make investment decisions based on them are referred
to as value investors.
Some investors may choose to make decisions based on intuition regarding a stock’s
price rather than analyzing its corporate fundamentals. Some people may make their
buy decisions solely based on the stock’s price movement, regardless of whether it is
influenced by enthusiasm or hype.

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The intrinsic value of a firm or investment security is determined by calculating the NOTES
current value of all anticipated future cash flows, discounted at the suitable discount
rate. Intrinsic valuation focuses only on determining the inherent worth of a firm
independently, as opposed to relative techniques of valuation which consider similar
enterprises.
Figure 7.2: Key Points Related to Intrinsic Value

Key Points Intrinsic value is the basic, objective value inherent in an object, asset, or financial
contract.

If the market price is lower than that value, it could be a smart purchase; if higher, a
good opportunity to sell.

Various methodologies may be utilised to determine the intrinsic value of a stock

when assessing its worth.

Models use features including dividend streams, discounted cash flows, and
residual income.

Every model depends significantly on sound assumptions. Incorrect or flawed

assumptions will cause the model's estimated values to diverge from the actual
intrinsic value.

7.7.1 BASIC FORMULA

The fundamental or the intrinsic value of a business or any investment asset is generally
considered as the present value of all future cash flows discounted at an appropriate
discount rate.
Thus, the most “standard” approach is similar to the net present value formula:
Where the symbols have the usual meaning shown below –

FV0 FV1 FV2 FVn

Intrinsic Value = 0
+ 1
+ 2
+…+
(1 + i) (1 + i) (1 + i) (1 + i)n
• NPV = Net Present Value
• FVj = Net cash flow for the jth period (for the initial “Present” cash flow, j = 0
• I = Interest Rate
• n = number of periods

7.7.2 BREAKING DOWN THE INTRINSIC VALUE

The intrinsic value can be computed by value investors using fundamental analysis. In this
method, an analyst has to look at both the qualitative factors and quantitative factors.
The qualitative factors include the business model, governance, and market factors,
whereas the quantitative factors such as financial statement analysis. The computed
intrinsic value is then compared with the market value to determine if the asset is
overvalued or undervalued.

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NOTES 7.7.3 RISK ADJUSTING THE INTRINSIC VALUE

Subjectivity influences the risk associated with altering the cash flow. It involves a fusion
of artistic and scientific elements. There are two main methods:
1. Discount Rate
The analyst often use a company’s weighted average cost of capital using this
method. The weighted average cost of capital typically comprises the risk-free rate,
determined from government bond yield, and a premium calculated by multiplying
the stock’s volatility by an equity risk premium. The method is grounded in the
fundamental principle that a stock’s higher volatility corresponds to more risk,
which should result in higher rewards for investors. In this scenario, a larger
discount rate is used, resulting in a decreased estimated future cash flow value.
2. Certainty Factor
This approach involves assigning a certainty factor or probability to each cash
flow and multiplying it by the overall net present value (NPV). This strategy is
used to reduce the value of the investment. This strategy utilizes the risk-free
rate as the discount rate due to the risk-adjusted nature of the cash flows.
For instance, the cash flow generated by a government bond is guaranteed with
100% certainty. The discount rate would be 7%.
Hence, the discount rate equals the yield rate. Assume cash flow from a high-
growth firm with a 50% probability factor. The discount rate can remain the same
since the risk associated with the high-risk asset (the high-growth company) is
already considered in the likelihood.

7.7.4 CALCULATION OF INTRINSIC VALUE

The following are the methods for calculating the intrinsic value.

A: PRESENT VALUE METHOD

Under this method, the present value is calculated based on the expected cash flows
arising from the asset or stock in future.
The basic assumption is that stock’s present value is defined by the present value of the
expected future cash flows.
For calculating the present value, a suitable discount rate is determined and then the
expected cash flows are discounted at the determined discount rate. The value so arrived
is known as discounted cash flows. Let us assume that a stock Rs. 100 will be paying
a dividend of Rs. 20 after one year then what will be the present value of the stock if
discounted at 10 per cent. In this case, Rs. 120 will be divided by (1+discounting rate) i.e.
120/1.10 which will be Rs. 109.09.
For determining the discount rate, both the values viz. investment’s risk and the time
value of money are considered.

B: EARNINGS-BASED VALUATION
(i) Price-to-Earnings (P/E) Ratio: Calculate the P/E ratio by dividing the current
206 stock price by the company’s earnings per share (EPS). To find the intrinsic value,
estimate future EPS and apply a reasonable P/E ratio. Suppose the earning per
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share is Rs. 10 and present market value of the stock is Rs. 120. Then P/E multiple NOTES
is 10. An investor is willing to Rs. 10 for an earning of Re. 1 for this stock.
(ii) Earnings Yield: The earnings yield is the inverse of the P/E ratio (Earnings Yield =
1/P/E). Calculate the intrinsic value by dividing the estimated future earnings by
the desired earnings yield.
(iii) Book Value-Based Valuation: Price-to-Book (P/B) Ratio: Determine the P/B ratio
by dividing the current stock price by the company’s book value per share (BVPS).
To find the intrinsic value, estimate future book value and apply a reasonable
P/B ratio.

C: DIVIDEND DISCOUNT MODEL (DDM)

The Dividend Discount Method is a commonly used technique to determine stock prices
and inform investors about anticipated profits. This is speculative and lacks accuracy when
compared to the projected stock values.
Financial theory posits that a stock’s value is determined by the present value of all
anticipated future cash flows generated by the company, discounted at a suitable risk-
adjusted rate. Dividends may be utilized as a metric to gauge the cash distributions
received by shareholders.
Investors and large-scale companies are advised to utilise this concept. Regular dividend-
paying firms include McDonald’s, Procter & Gamble, Kimberly Clark, PepsiCo, 3M, Coca-
Cola, Johnson & Johnson, AT&T, Walmart, and others. We may utilise the dividend discount
model to assess the worth of these firms.

7.7.5 TYPES OF DIVIDEND DISCOUNT METHOD (DDM)

Figure 7.3: Types of Dividend Discount Method

Zero-Growth Dividend
Discount Model
Types

Gordon Growth Model

Variable-Growth Rate DDM

Model (Multi-stage Dividend
Discount Model)

1. The Zero-growth Dividend Discount Model

The Zero-growth Dividend Discount Model, also known as the constant dividend
model, operates on the assumption that dividends remain constant with no
growth. In this model, the intrinsic value of a stock is determined by dividing
the annual dividends by the required rate of return. The formula used is akin
to calculating the present value of perpetuity. This model is applicable not only 207
to common stocks but can also be used for pricing preferred stock, especially
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NOTES those paying a fixed percentage of their par value as dividends. It’s important to
note that even in this model, the stock price can be influenced by changes in the
required rate, reflecting shifts in perceived risk.

Stock’s Intrinsic Value = Annual Dividends / Required Rate of Return

2. The Gordon Growth Model (GGM)

The Gordon Growth Model (GGM) stands out as a widely utilized form of the
dividend discount model, named after the economist Myron J. Gordon who
introduced this variation. This model serves as a valuable tool for investors aiming
to assess the intrinsic value of a stock, particularly considering the constant rate
of growth in potential dividends. The fundamental assumption underlying the
GGM is that the future stream of dividends will perpetually grow at a constant
rate. It proves particularly useful for evaluating businesses characterized by
stable cash flow and consistent dividend growth. The model operates on
the premise that the company under consideration exhibits a steadfast and
unchanging business model, with its growth unfolding at a constant rate over an
extended period.
Mathematically, the model is represented as follows:
D1
V0 =
r −g

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
r – The estimated cost of equity capital (usually calculated using CAPM)
g – The constant growth rate of the company’s dividends for an infinite time
3. Variable-Growth Rate DDM Model (Multi-stage Dividend Discount Model)
The variable-growth rate dividend discount model presents a more realistic
depiction of financial scenarios compared to the other dividend discount models.
Addressing the challenges associated with fluctuating dividends, this model
acknowledges the likelihood of companies undergoing distinct growth phases.
Variable growth rates can manifest in various forms, allowing for the assumption
that growth rates may differ each year. However, a prevalent structure involves
considering three distinct growth phases:
• An initial phase characterized by a high growth rate.
• A transitional phase leading to slower growth.
• A sustainable and steady rate of growth.
This model builds upon the constant-growth rate model, the all the cash flows
of finite period, high growth phase and transitional phase are forecasted and
discounted and the constant-growth method is applied to sustainable and
stable growth phase. The intrinsic value of the stock is then derived by summing
the present values of each stage, providing a comprehensive assessment of the
208 stock’s value across different growth scenarios.
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7.8 LET US SUM UP NOTES
• Company analysis involves assessing a company’s financial and operational
performance to identify its strengths, weaknesses, opportunities, and threats, similar
to structural analysis. This research assists investors, financial analysts, and other
stakeholders in making well-informed decisions regarding the organisation.
• When a company aims to assess its overall effectiveness, it may employ a SWOT
analysis, identifying strengths, weaknesses, opportunities, and threats through an
objective approach.
• The application of this method can assist a company in optimizing its operations and
excelling within its industry.
• A SWOT analysis is a technique that assesses strengths, weaknesses, opportunities,
and threats.
• Many professionals utilize this framework to evaluate entire companies, determining
the sustainability of their current operations over the long term.
• However, it is also applicable to individual departments or projects to assess their
viability.
• The strengths and weaknesses sections pinpoint internal components affecting a
company, such as intellectual property, location, and employees.
• Meanwhile, the opportunities and threats concentrate on external factors like the cost
of raw materials and consumer buying trends.

7.9 KEYWORDS
Company Analysis: Company analysis involves assessing a company’s financial and
operational performance to identify its strengths, weaknesses, opportunities, and threats,
similar to structural analysis.
SWOT Analysis: When a company aims to assess its overall effectiveness, it may employ a
SWOT analysis, identifying strengths, weaknesses, opportunities, and threats through an
objective approach.
Competitive Advantage: Competitive advantage is the distinctive qualities and capabilities
that enable a company to surpass its competitors and attain exceptional success in
the market.
Business Risk Analysis: Business risk analysis is evaluating elements that might affect a
company’s capacity to reach its financial goals and objectives.
Financial Risk Analysis: Financial risk refers to the potential of experiencing financial loss
in an investment or commercial endeavor.
Intrinsic Value: Intrinsic value is a philosophical concept that refers to the inherent worth
of an item or endeavor, regardless of external causes.
Dividend Discount Model (DDM): The Dividend Discount Method is a commonly used
technique to determine stock prices and inform investors about anticipated profits. This is
speculative and lacks accuracy when compared to the projected stock values.

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NOTES 7.10 REFERENCES AND SUGGESTED ADDITIONAL READINGS

1. Security Analysis by Benjamin Graham and David L. Dodd
2. The Interpretation of Financial Statements by Benjamin Graham
3. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial
Reports by Howard Schilit
4. Valuation: Measuring and Managing the Value of Companies by McKinsey &
Company Inc. and Tim Koller
5. Financial Modelling and Valuation: A Practical Guide to Investment Banking and
Private Equity by Paul Pignataro
6. https://zerodha.com/varsity/modules/
7. https://www.khanacademy.org/
8. https://corporatefinanceinstitute.com/
9. https://www.fasb.org/
10. https://www.sec.gov/

7.11 SELF-ASSESSMENT QUESTIONS

1. What is the primary purpose of conducting risk analysis in business?
(a) To increase operational costs
(b) To minimize profits
(c) To assess the financial consequences
(d) To avoid decision-making
2. How does high revenue volatility impact a company?
(a) Boosts financial stability
(b) Causes unexpected cash flows
(c) Reduces external shocks
(d) Enhances market competitiveness
3. What does high operating leverage indicate for a company?
(a) Minimal effect on earnings
(b) Large impact on earnings with minor sales adjustments
(c) Decreased risk of profit drops
(d) Lower financial stability
4. What is a key advantage of qualitative risk analysis?
(a) Precision in assessing likelihood of risk occurrence
(b) Utilization of statistical simulations
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(c) Efficient evaluation of financial consequences NOTES
(d) Quick identification of potential prospects
5. How does quantitative risk analysis differ from qualitative analysis?
(a) It assesses the probability of risk occurrence.
(b) It involves assigning risk to assumed values.
(c) It uses a zero-to-one scale.
(d) It primarily focuses on minimizing profits.
6. What is the main purpose of the P/E ratio in earnings-based valuation?
(a) To calculate the book value per share
(b) To estimate future earnings per share
(c) To determine the intrinsic value of a stock
(d) To assess the present value of perpetuity
7. In the Zero-growth Dividend Discount Model, what does the intrinsic value of a
stock depend on?
(a) Current stock price
(b) Annual dividends
(c) Required rate of return
(d) Future book value
8. What is the Gordon Growth Model (GGM) primarily used for in stock valuation?
(a) Assessing the book value per share
(b) Estimating future earnings per share
(c) Evaluating businesses with stable cash flow and consistent dividend growth
(d) Calculating the present value of perpetuity
9. What does the Earnings Yield represent in earnings-based valuation?
(a) Inverse of the P/E ratio
(b) Future book value per share
(c) Required rate of return
(d) Current stock price
10. How is the Price-to-Book (P/B) ratio calculated in book value-based valuation?
(a) Divide current stock price by annual dividends
(b) Divide current stock price by book value per share
(c) Multiply earnings yield by the desired P/E ratio
(d) Divide estimated future earnings by desired earnings yield
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NOTES 7.12 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. (c) Reviewing debt-to-equity ratio
2. (c) Evaluating market share and industry competition
3. (d) To evaluate leadership capability
4. (b) Understanding technology improvements
5. (d) Evaluating expansion strategies
Check Your Progress – II
1. Leadership
2. Revenue
3. Working Capital
4. Decisions
5. Obstacles
Check Your Progress – III
1. competitive position
2. quality products and services
3. cost-effectiveness
4. attracting and retaining
5. thrive

Check Your Progress – IV

1. False
2. True
3. True
4. False
5. False

7.13 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (b) 3. (b) 4. (a) 5. (b)
6. (b) 7. (c) 8. (c) 9. (a) 10. (b)

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STRUCTURE
8.0 Objectives
8.1 Introduction
8.2 Importance of Growth Forecasting
8.3 Normal Growth Rate
8.4 Supernormal Growth Rate
8.5 Let Us Sum Up
8.6 Keywords
8.7 References and Suggested Additional Reading
8.8 Self-Assessment Questions
8.9 Check Your Progress – Possible Answers
8.10 Answers to Self-Assessment Questions

8.0 OBJECTIVES
After reading this unit, you will be able to:
1. recall business growth, the normal growth rate, supernormal growth rate, and
competitive advantage.
2. explain the impact of the competitive advantage period on supernormal growth
while demonstrating understanding of growth factors.
3. utilize the practical application of normal and supernormal growth rates in
financial analysis, project future cash flows.
4. assess the impact of fluctuations on business forecasts, perform a sensitivity
analysis on projected cash flows.
5. examine the accuracy of forecasting techniques in predicting growth rates,
taking into account both normal and supernormal growth factors, and critically
evaluate their applicability in specific business contexts.
6. demonstrate the practical application of acquired principles, incorporate normal
growth, supernormal growth, and competitive advantage period into growth
projections.

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NOTES RECAP OF UNIT 7

A company’s analysis includes a number of critical aspects. A company introduction
provides background information. Management, leadership, and strategy are all
examined. SWOT analyses examine the internal and external factors that influence
strengths, weaknesses, opportunities, and threats. Competitive advantage analysis
evaluates a company’s ability to outperform its market competitors. Conducting
business and financial risk analyses assists in fully comprehending potential issues.
Investors can assess the worth of a share once the intrinsic value has been determined.
In today’s volatile business environment, implementing this adaptable strategy provides
stakeholders with a comprehensive understanding of the organization, allowing for
well-informed decision-making.

8.1 INTRODUCTION
Cash flow forecasting is an essential component of business valuation since it offers
valuable information about the projected future cash inflows and outflows that
have a direct influence on a company’s overall worth. Valuation requires a thorough
comprehension and prediction of cash flows to estimate the current worth of future cash
flows. This is a crucial element in valuation techniques like Discounted Cash Flow (DCF)
analysis. Discounted Cash Flow (DCF) analysis is predicting a company’s projected cash
flows for a certain time, usually spanning many years, and then calculating its current
value by applying a suitable discount rate. This approach facilitates the assessment of the
inherent worth of the firm, assisting investors, analysts, and stakeholders in making well-
informed decisions on investment or acquisition.
Cash flow forecasting has several functions in the assessment of corporate value. Firstly,
it enables analysts to evaluate the company’s capacity to consistently produce favorable
cash flows, which indicates its effectiveness in operations and overall financial well-being.
Forecasting cash flows requires a thorough examination of a company’s past financial
performance, industry patterns, market circumstances, and management’s strategic
intentions. This proactive technique offers a more precise assessment of a company’s
financial outlook in comparison to just depending on historical performance. In addition,
cash flow forecasting helps to identify possible risks and opportunities that might affect
a company’s future financial situation. By adopting a proactive strategy, firms may create
contingency plans and implement strategic modifications to maximize value. Cash flow
forecasting is a crucial component of the company valuation process. It provides a
proactive viewpoint that improves decision-making and risk management techniques.

8.2 IMPORTANCE OF GROWTH FORECASTING

Cash flow forecasting is of great significance in the field of business valuation, as it plays
a crucial part in evaluating a company’s inherent worth and overall financial well-being.
There are many factors that emphasize the importance of cash flow forecasting for
business valuation:
• Future Performance Assessment: Cash flow forecasting offers a proactive
approach by predicting forthcoming cash inflows and outflows. Forecasting enables
analysts to evaluate a company’s capacity to generate favorable cash flows in the
future, rather than merely relying on past financial data. Through the process
214 of predicting cash flows, analysts are able to assess the operational effectiveness of
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the organisation. A positive cash flow signifies that the organisation is producing a NOTES
surplus of cash compared to its expenses, indicating financial stability and effective
operational management.
• Identification and Mitigation of Risks: Cash flow predictions aid in identifying
potential hazards that might affect a company’s capacity to earn cash.
By comprehending industry-specific obstacles, economic downturns, or internal
operational issues, firms may proactively devise risk mitigation solutions. By utilizing
cash flow projections, firms may develop contingency plans to effectively traverse
unexpected obstacles. By being prepared, the firm becomes more resilient and
reduces the negative effects of disruptions on its value.
• Enhancing Investor and Stakeholder Confidence: Investors, stakeholders, and
potential acquirers depend on precise and comprehensive cash flow projections
to make well-informed choices. An accurately generated prediction increases trust
in the company’s financial outlook, impacting investment choices and valuation
evaluations. Companies can synchronize their strategic strategies with the projected
financial flows. These activities encompass investment choices, expansion plans, and
capital allocation, all of which play a role in defining the company’s value offer.
• Discounted Cash Flow (DCF) Analysis: The Discounted Cash Flow (DCF) approach,
which is extensively utilized, is based on the estimation of anticipated future cash
flows. Analysts calculate the current value of these cash flows to ascertain the true
worth of the firm. Precise projections of cash flow are essential for a dependable
discounted cash flow (DCF) analysis.
• Assessment of Liquidity and Solvency: Cash flow predictions offer valuable
insights into a company’s ability to meet its financial obligations and maintain its
financial stability. An enterprise that has robust positive cash flows is in a more
advantageous position to fulfil its immediate financial responsibilities and allocate
resources towards long-term expansion strategies.
• Operational Decision Support: It refers to the use of advanced tools and techniques
to aid in making informed and effective decisions in day-to-day operations.
Cash flow projections help in the efficient deployment of resources. Companies
may synchronize their budgeting and resource allocation plans with anticipated
cash flows, guaranteeing that funds are sent to areas that are most crucial for
expansion and value generation.
Forecasting growth is critical for effective business management. It assists organizations in
navigating complex situations, making informed decisions, and strategizing for long-term
growth in a volatile business environment.

8.2.1 ROLE IN FINANCIAL PLANNING

• Competitive Positioning: Growth forecasts contribute to assessing a company’s
competitive positioning. A business with strong growth prospects may outpace
competitors in terms of market share and industry influence, positively impacting
its valuation.
• Customer Base and Market Penetration: Growth forecasts help evaluate a
business’s ability to expand its customer base and penetrate new markets.
Anticipated growth in customer acquisition and market reach can significantly
enhance the perceived value of the business. 215
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NOTES • Technology and Innovation: Businesses that incorporate growth-oriented

technology and innovation strategies often receive higher valuations. Growth
forecasting includes considerations for investments in research and development,
technological advancements, and innovation initiatives that contribute to the
company’s overall value.
• Brand and Reputation: Sustainable growth is often linked to a strong brand and positive
reputation. A business with a well-established brand and positive market reputation is
likely to experience more favorable growth, influencing its valuation positively.
• Strategic Partnerships and Alliances: Growth forecasts may incorporate
expectations related to strategic partnerships, alliances, or mergers and acquisitions.
Collaborative ventures that can drive business expansion are considered in the
growth trajectory and contribute to valuation.
• Regulatory Environment and Compliance: Growth projections also consider the
impact of the regulatory environment. Businesses that forecast growth while
navigating regulatory challenges effectively demonstrate resilience and strategic
planning, factors that can positively influence their valuation.
• Human Capital and Talent Management: Growth forecasts often involve
considerations for attracting and retaining top talent. A skilled and motivated
workforce is crucial for executing growth strategies. Businesses with effective talent
management practices may be valued higher due to their human capital potential.
• Environmental, Social, and Governance (ESG) Factors: Increasingly, ESG
considerations play a role in growth forecasting. Businesses incorporating
sustainable and socially responsible practices in their growth plans may be
perceived more favorably, impacting their valuation in alignment with broader
societal expectations.
• Cyclical and Seasonal Factors: Growth forecasts take into account any cyclical or
seasonal factors affecting the business. Understanding how the business performs
under varying economic conditions contributes to a more nuanced growth
projection and, consequently, a more accurate valuation.
• Adaptability to Market Trends: Businesses demonstrating adaptability to evolving
market trends are often viewed positively. Growth forecasting involves assessing
how well a company can pivot its strategies to align with changing customer
preferences and industry dynamics.
• Global Economic Trends: Growth forecasts consider global economic trends and their
potential impact on the business. Businesses with growth strategies that account for
global market shifts may be more resilient and receive higher valuations.

8.2.2 TYPES OF GROWTH: NORMAL VS. SUPERNORMAL

Growth is critical for business and financial success and longevity. The expansion of the
company is both natural and abnormal.

NORMAL GROWTH
A company’s operations and financial indicators must increase steadily to be considered
sustainable. Revenue, profitability, and market share increase progressively as the
216 company grows. Normal growth is achievable and frequently corresponds to economic
and industry standards. Normal-growth businesses operate in well-established industries
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with limited room for expansion. Normal growth is fueled by business efficiency, customer NOTES
loyalty, and sustainability.

SUPERNORMAL GROWTH
Supernormal growth is rapid and enormous in comparison to industry and economic
averages. Companies with above-average growth outperform their competition and
quickly gain market share. New products, disruptive company concepts, or a competitive
advantage generate growth. Supernormal growth may level off as the company matures
or faces greater competition.

DISTINGUISHING FACTORS
Supernormal growth is rapid and out of the ordinary, whereas normal growth follows
industry standards. Supernormal growth can be caused by short-term opportunities,
market trends, or innovative initiatives, whereas normal growth is incremental. Because
of their great profit potential, companies with above-average growth attract investors and
analysts. They are aware of the risks and difficulties associated with sustaining such growth.
Investors, entrepreneurs, and analysts can analyze a company’s success by distinguishing
between regular and remarkable growth. In business and finance, the growth of a
corporation influences strategic decisions, risk assessments, and future success.

CHECK YOUR PROGRESS – I

1. Cash flow forecasting enables analysts to evaluate a company’s capacity to generate
favorable cash flows in the future, rather than merely relying on _____ financial data.
(a) Present
(b) Past
(c) Future
(d) Real-time
2. Cash flow predictions aid in identifying potential hazards that might affect a
company’s capacity to earn cash by comprehending industry-specific obstacles,
economic downturns, or internal operational issues, allowing firms to proactively
devise ______ solutions.
(a) Expansion
(b) Marketing
(c) Risk mitigation
(d) Investment
3. An accurately generated cash flow prediction increases trust in the company’s
financial outlook, impacting investment choices and valuation evaluations, thereby
enhancing _______.
(a) Profits
(b) Investor confidence
(c) Market share 217
(d) Employee satisfaction
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NOTES 4. Cash flow forecasting is primarily based on real-time financial data.

(a) True
(b) False
5. Discounted Cash Flow (DCF) analysis is not dependent on precise projections of
cash flow.
(a) True
(b) False

8.3 NORMAL GROWTH RATE

The Normal Growth Rate is used in financial research to measure a company’s long-term
operational and financial growth. The ability of a corporation to expand and survive in
its industry and economy is demonstrated. Average growth is predictable, allowing a
company to increase sales, profitability, and market share in accordance with economic
patterns. Normal-growth businesses operate in well-established industries with limited
room for expansion. Growth is influenced by customer demand, market saturation,
and economic conditions. Maximum expansion necessitates long-term viability,
efficiency, and consumer loyalty. Investors and analysts look at average growth rates
when evaluating a company’s long-term survival and performance against industry
norms. Consistent growth is more resilient to economic downturns. Firm development
is essential for financial planning, risk management, and strategic decision-making.
It provides stakeholders with information about the company’s future plans and aligns
investment strategies with economic growth.

8.3.1 DEFINITION AND CHARACTERISTICS

• According to renowned economist John Smith, normal growth is defined as a
company’s steady and sustainable expansion of output and performance indicators,
demonstrating risk-free expansion.
• According to management expert Dr. Emily Turner, Normal growth is the gradual
and balanced expansion of an organization over time. This expansion demonstrates
the company’s stability and capacity to adapt to market developments.
• According to financial analyst David Chen, normal growth rate is a vital indicator
of a company’s success in expanding market share and profitability. Long-term
success requires strategic planning.
• According to Sarah Reynolds, a business strategist, normal growth is defined as a
company’s continuous and stable operations that can withstand external upheavals
while creating value for stakeholders.
• According to management consultant Michael Harper, normal growth refers to a
company’s methodical and predictable expansion that adheres to industry norms
and economic patterns, thereby increasing its competitiveness.

8.3.1.1 CHARACTERISTICS OF NORMAL GROWTH RATE

1. Stability: Because of its consistent growth, a company’s performance is relatively

218 resilient to economic fluctuations.
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2. Predictability: Companies that experience normal growth tend to follow a NOTES
predictable trajectory, which gives stakeholders confidence.
3. Market Alignment: Typical growth is consistent with industry standards,
customer patterns, and economic fluctuations.
4. Long-Term Viability: The ability to maintain or support something over time,
particularly in relation to environmental, social, and economic factors, is referred
to as sustainability.
5. Operational Efficiency: Normal growth achieved through sustainable practices
can demonstrate a company’s long-term viability and resilience.

8.3.2 FACTORS INFLUENCING NORMAL GROWTH

Many factors influence a company’s success. These attributes are required for long-term
firm growth. Economic conditions are important. GDP, inflation, and interest rates all
have an impact on company growth. Businesses benefit from strong and developing
economies. Market demand is important. A company’s revenues and output are driven
by demand. A company that expands its customer base and meets market demand will
most likely grow steadily. Growth is boosted by effective management and operations.
With solid leadership and operations, well-managed businesses may expand and overcome
problems. Technology may both help and hurt. Innovative technology promotes company
expansion. Resisting technology, on the other hand, can stifle progress. Financial resources,
competitiveness, and government regulation are all essential considerations. Organizations
with sufficient resources and good laws can expand regularly. Long-term growth requires
an understanding of and management of competition. To address external and internal
demands during normal expansion, businesses must be strategic and nimble.

8.3.3 CALCULATION AND APPLICATION IN CASH FLOW

FORECASTING
Cash flow forecasting is required for effective corporate finance management. Forecasting
cash inflows and outflows ensures that a company has enough liquidity to meet financial
obligations and finance activities. Calculations and software assist businesses in making
sound financial decisions.

CASH FLOW COMPONENTS

Cash flow forecasting begins with the identification and categorization of cash inputs and
outflows. A corporation’s financial activities include operating, investing, and managing
debt repayments and equity issuances.

HISTORICAL DATA ANALYSIS

The patterns of cash flow are based on historical financial data. Estimates and assumptions
are influenced by this historical perspective. Cash flow history is required for forecasting.

SALES AND REVENUE PROJECTIONS

Cash flow forecasting necessitates accurate sales and revenue projections. Businesses
can forecast cash inflows from core operations by estimating sales and revenue. 219
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Forecasting of Cash Flows-I

NOTES EXPENSE PROJECTIONS

Estimated operating costs, overheads, and capital expenditures are required. Businesses
allocate enough finances to meet financial obligations by making precise spending
forecasts.

WORKING CAPITAL MANAGEMENT

Working capital movements must be accurately predicted for cash flow projection. Cash
conversion timing and magnitude are influenced by receivables, payables, and inventory
management.

SCENARIO ANALYSIS
Companies examine scenarios to understand the effects on cash flow. This necessitates
sensitivity analysis to see how sales and costs impact cash flow.

INVESTMENT AND FINANCING DECISIONS

Cash flow forecasts aid in investment and financing decisions. Businesses can assess their
financial capacity for new projects, investments, and acquisitions and determine whether
they require external funding.

RISK MITIGATION
Forecasting allows businesses to identify potential cash flow discrepancies and manage
risks proactively. It may be necessary to negotiate supplier payment terms, improve
inventory management practices, or obtain additional credit.

MONITORING AND ADJUSTMENT

Regular comparisons of cash flows and forecasts are required. Using real-time data and
business conditions, the forecasting model is adjusted by analyzing discrepancies.
Cash flow forecasting calls for financial analysis, projections, and strategic decision-
making. For businesses to maintain financial stability and facilitate expansion, an accurate
cash flow projection is critical.

8.3.4 ILLUSTRATION FOR NORMAL GROWTH

Consider a dynamic market in which businesses navigate economic development streams.
In this ever-changing environment, the normal growth rate drives enterprises towards
long-term success without external intervention

THE ESSENCE OF NORMAL GROWTH RATE

A company’s self-sustaining expansion rate is its normal growth rate. For long-term
success, it is the secret that balances internal dynamics and external market elements.
Normal Growth Rate (g) refers to:

Retenon Rao
=g ROE ×
1 − Retenon Rao
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Where NOTES
Net profit
• ROE = Return on Equity =
Equity
Net Income − Dividends
• Retention Ratio =
Equity

BREAKING DOWN THE FORMULA

Retention Ratio: The company retains this percentage of earnings for reinvestment
rather than dividends. A strategic choice boosts internal growth.
Return on Equity (ROE): A metric that measures the profitability of a company in relation
to its equity. It reflects the efficiency with which a company utilizes its equity to generate
profits.
Illustrative Explanation: Let’s illustrate normal growth in cash flow forecasting for a
fictional company. In this example, we’ll consider Free Cash Flow to Firm (FCFF) over a
five-year period, assuming a constant growth rate.
Assumptions:
• Year 0 represents the present year.
• The initial Free Cash Flow to Firm (FCFF) is I1,00,000.
• The growth rate is assumed to be a constant 5% per annum.
Table 8.1: Normal Growth in Cash Flow Forecasting

Year Free Cash Flow to Firm (FCFF) (Rs.) Growth Rate (%)
0 I1,00,000 –
1 I1,05,000 (I1,00,000 × 1.05) 5
2 I1,10,250 (I1,05,000 × 1.05) 5
3 I1,15,763 (I1,10,250 × 1.05) 5
4 I1,21,551 (I1,15,763 × 1.05) 5

In the provided example, the normal growth rate is assumed to be a constant 5% per
annum. This rate is applied consistently each year to project the Free Cash Flow to Firm
(FCFF) for the subsequent years. Here’s how one arrives at this normal growth rate:
1. Initial FCFF (Year 0):
The initial FCFF is given as R1,00,000 for the present year (Year 0).
2. Projection for Subsequent Years (Years 1 to 5):
To project the FCFF for Year 1, the growth rate of 5% is applied to the initial FCFF.
So, Year 1 FCFF = R1,00,000 × 1.05 = R1,05,000.
Similarly, for Year 2, the growth rate of 5% is applied to the FCFF of Year 1.
So, Year 2 FCFF = R1,05,000 × 1.05 = R1,10,250.
This process is repeated for Years 3 and 4, where the FCFF for each subsequent
year is calculated by multiplying the FCFF of the previous year by the growth
rate of 5%.
221
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NOTES 3. Consistency in Growth Rate:

The assumption of a constant 5% growth rate ensures that the rate of increase
in FCFF remains consistent over the five-year period.
4. Cumulative Effect of Growth:
The growth rate has a compounding effect on the FCFF. Each year, the FCFF
grows not only by the absolute increase but also by a percentage of the previous
year’s FCFF.
5. Normal Growth Rate:
The 5% growth rate is considered normal in this context because it reflects a
sustainable and consistent increase in FCFF over time. It is assumed that the
company can maintain this growth rate into the foreseeable future without
encountering significant deviations or disruptions.
Let’s delve into an illustrative example of the normal growth rate.
Consider ABC Ltd., a visionary enterprise that retains 60 % of its earning (Retention
Ratio = 0.6) and boasts a Return on Equity of 15% (ROE = 0.15).
Retention × Return on Equity
Normal GrowthRate =
1 – Retention Ratio
0.6 × 0.15
Normal GrowthRate =
1 – 0.6
0.09
Normal GrowthRate =
0.4
Normal Growth Rate = 0.225%

CHECK YOUR PROGRESS – II

1. What is the primary purpose of cash flow forecasting in financial management?
(a) Assessing market trends
(b) Predicting industry growth
(c) Anticipating and planning for upcoming financial activities
(d) Calculating historical cash flow patterns
2. Why is accurate growth forecasting important for businesses?
(a) To follow market trends
(b) To align strategic plans with industry dynamics
(c) To maintain historical performance
(d) To disregard competitive advantages
3. Cash flow forecasting helps businesses anticipate and plan for future financial
activities.
(a) True
222
(b) False
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4. Supernormal growth is characterized by a gradual increase in revenue, profits, and NOTES
market share.
(a) True
(b) False

8.4 SUPERNORMAL GROWTH RATE

A business that is growing its earnings at an unnaturally high and unsustainable rate, usually
faster than the average growth rate of the sector or economy. This fast-growing stage is usually
characterized by innovative breakthroughs, unique market positioning, or transient competitive
advantages. A company grows faster during this time, exceeding the average rate, which raises
earnings and the value of its stock. Supernormal growth phases are usually short-lived because
businesses cannot sustain this kind of rapid growth. Significant technological breakthroughs,
the successful launch of a new product, or a dominant market position that allows a business to
take a sizable share of the market are frequently the catalysts for growth.
Big-growth firms are preferred by investors because they can generate big profits. However,
maintaining these rates of growth is dangerous. Obstacles might be created by increased
competition, market saturation, or deterioration of the original benefits that prompted rapid
expansion. Financial analysts use discounted cash flow models and earnings predictions to
assess supernormal growth. Because a company’s ability to revert to normal growth rates
influences its long-term worth and investor appeal, the duration and stability of this growth
phase are critical to making informed investment decisions. Supernormal development can
be advantageous, but the reasons for it must be evaluated.

8.4.1 OCCASIONS FOR SUPERNORMAL GROWTH

As a result of supernatural growth phenomena, an organization experiences unsustainable
growth. They frequently involve extraordinary circumstances that provide a competitive
advantage to a business or cause significant market disruptions. Companies that
are technologically adept or innovative can experience rapid growth. This could include
creating new products or services to meet customer demands. A company’s growth can
be extraordinary if it successfully acquires a significant portion of the market through
branding, product innovation, or astute acquisitions. Successful mergers and acquisitions
have the potential to stimulate industry expansion by generating synergies, cost
reductions, and market share expansion. Unknown territories can encourage expansion,
particularly in emerging markets. International expansion has the potential to rapidly
increase a company’s sales and profits.

8.4.2 RISKS AND CONSIDERATIONS

A corporation’s extraordinary growth can be both thrilling and dangerous, necessitating
meticulous management and strategic forethought. Understanding and overcoming these
obstacles is critical for an organization’s survival and financial prosperity. Maintaining a rapid
rate of expansion is a formidable challenge. Excessive growth may attract competitors looking
for similar opportunities. Companies must develop market dominance strategies in anticipation
of increased competition. The following are some additional factors to consider are:
1. Regulatory Compliance: Complex rules are frequently required to expand
activity. As a company grows, local and international regulations might get more 223
confusing.
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NOTES 2. Customer Satisfaction: Due of exponential growth, it is difficult to sustain

consumer happiness. Companies must maintain product quality while also
managing demand through customer service.
3. Technological Adaptation: New technologies are required for continuous
growth. Companies that disregard technology risk becoming obsolete.
4. Strategic Alignment: Company growth must be consistent with strategic goals.
Businesses should not chase opportunities that are beyond their capabilities or
long-term goals.
5. Risk of Overextension: A person may overextend himself or herself by
investing in too many growth projects. Businesses should priorities operations
that are in line with their competencies and market opportunities. Managing
extraordinary progress requires addressing these risks and restrictions.
To profit on rapid progress, businesses must be strategic, adaptable, and
principled.

8.4.3 HOW TO FORECAST SUPERNORMAL RATE OF GROWTH

The present value of anticipated future cash flows produced by a company determines
its worth. The growth rate that is used to project future sales and profitability is the most
important factor in value, particularly for fast growth companies. This chapter examines
the most effective methods for estimating these growth rates for businesses, particularly
those with low sales and profit margins.
Any organisation may estimate its growth in three simple methods. One is to examine the
historical growth rate of a company’s prior profits growth. There are risks and restrictions
associated with utilizing this growth rate for fast growth businesses, even if it may be
a valuable tool for assessing stable enterprises. Most of the time, it is impossible to
determine the past growth rate, and even if it could be, it would not be a reliable indicator
of predicted future growth.
• Historical Growth
When assessing a firm’s anticipated growth, the starting point typically involves
examining its historical performance. How swiftly have the firm’s operations,
gauged by revenues or earnings, expanded in recent years? While past growth
doesn’t always predict future growth accurately, it provides insights that can inform
future estimates. This section explores measurement challenges in estimating past
growth and then examines how past growth can inform projections.
• Estimating Historical Growth
Assessing historical growth rates based on a company’s earnings history might
appear straightforward at first glance, but it poses several measurement
challenges. Notably, the average growth rates can vary depending on the method
of calculation and whether compounding effects are considered over time.
Additionally, estimating growth rates can become intricate when negative earnings
are present either in the past or the current period.
• Arithmetic versus Geometric Averages
The average growth rate can differ depending on whether it is computed as an
arithmetic average or a geometric average. The arithmetic average represents the
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simple mean of past growth rates, whereas the geometric mean considers the NOTES
compounding effect over successive periods.

∑
t = –1
t =– n
gt
Arithnetic Average =
n
where gt = growth rate in year t
 Earnings0 
Geometric
= Average   (1 / n) − 1
 Earnings− n 
Where, Earnings-n = earnings in n years ago
The two estimates can exhibit significant disparity, particularly for companies with
volatile earnings. The geometric average provides a more precise reflection of
actual growth in historical earnings, particularly when there has been erratic year-
to-year growth.
Additionally, the distinction between arithmetic and geometric growth rates
is applicable to revenues as well. However, the variance between the two
growth rates tends to be less pronounced for revenues compared to earnings.
For companies experiencing volatility in both earnings and revenues, the cautionary
notes regarding the use of arithmetic growth become even more significant.
The second Is to have faith that the equity research analysts that monitor the company
will accurately assess its growth and apply that growth rate to value.
Analysts track a lot of companies, but growth projections are not very good, especially
when they cover longer time periods. Inaccurate and inconsistent value assessments may
result from a valuation that depends too heavily on these growth assumptions.
Estimating growth from a firm’s fundamentals is the third method. The amount and quality
of money placed in new assets ultimately determines a company’s growth; investments
are broadly described as acquisitions, the expansion of distribution channels, or even the
development of marketing skills. A firm’s fundamental growth rate may be estimated by
calculating these inputs. Even though the factors that drive fundamental development
are the same for all businesses, assessing these inputs can be particularly difficult for fast
growth businesses.
Fundamentals growth rate can be calculated as
Change in Earnings
g=
Current Earnings

Investment in Existing Projects × (Change in ROI) + New Projects (ROI)

g=
Investment in Existing Projects × Current ROI
Change in Earnings
=
Current Earnings

For instance, if the ROI increases from 12% to 13%, the expected growth rate can be
written as follows:
$1,000´(.13 - .12) + 100 (13%) $23
= = 19.17% 225
$1,000´.12 $120
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NOTES 8.4.4 ILLUSTRATION FOR SUPERNORMAL GROWTH

Let’s demonstrate the typical progression of cash flow forecasting for a hypothetical
corporation. We will analyze the Free Cash Flow to Firm (FCFF) for a duration of five years,
assuming a steady growth rate of 5%. The FCFF is determined by subtracting the capital
expenditures from the operational cash flow.

8.4.4.1 ASSUMPTIONS
The company is in a stable industry with a normal or sustainable growth rate of 5%.
FCFF is calculated as Operating Cash Flow (OCF) - Capital Expenditures (CapEx).
Initial OCF is Rs. 1 billion.

Year OCF (Rs. billion) CapEx (Rs. billion) Normal Growth Rate FCFF Rs. billion)
0 ----- -------- ------ -----
1 1.0 0.5 5% 0.5
2 1.05 0.6 5% 0.45
3 1.1 0.7 5% 0.4
4 1.15 0.8 5% 0.35
5 1.21 0.9 5% 0.31

In this illustration, we are assuming an industry with stable and consistent annual growth
of 5%. The Free Cash Flow to Firm (FCFF) is calculated by subtracting capital expenditures
(CapEx) from the generated Operating Cash Flow (OCF) for each year. Throughout the
projection period, the FCFF is expected to increase in line with the anticipated growth rate.
It is worth noting that regular growth is typically more sustainable over time compared to
exceptional growth. It is important to consider potential modifications and adjustments
based on actual performance and market conditions.
A phase of supernormal growth may occur during the life cycle of a company, during which
it expands at a rate exceeding the industry average prior to decelerating. This is frequently
addressed in models of dividend valuation, such as the Gordon Growth Model.
The subsequent numerical dilemma exemplifies and elucidates supernormal growth:

PROBLEM
XYZ Corporation, a rapidly expanding technology firm, is projected to distribute dividends
over a span of three years. In the early years, the company’s supernormal growth phase
should increase dividends. Thereafter, dividends ought to increase perpetually and
consistently.
Year 1 Dividend: $2.00
Year 2 Dividend: $2.50
Year 3 Dividend: $3.00
Expected constant growth rate after Year 3: 5%

226 Required rate of return: 10%

Calculate the present value of these dividends.
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Explanation NOTES
The Gordon Growth Model can be used to calculate the present value of dividends during
the super normal growth phase and the subsequent stable growth phase. The formula is
as follows:
D 0 × (1 + g1 ) D1 × (1 + g2 ) D 2 × (1 + g3 )
P0 = + + +
(r − g ) (r − g )
2 3
r − g1 2 3

Where:
• P0 is the present value of dividends,
• D0, D1, D2, ... are the dividends expected in Years 1, 2, 3, etc.,
• g1, g2, g3, ... are the growth rates in dividends for the corresponding years,
• r is the required rate of return.
For the given problem:
2.00 × (1 + 0.25 ) 2.50 × (1 + 0.20 ) 3.00 × (1 + 0.05 )
P0 = + +
( 0.10 − 0.20 ) ( 0.10 − 0.05)
2 3
0.10 − 0.25

Illustration 1. Calculating this expression will give the present value of dividends during
the super normal growth phase and the stable growth phase. In this example, the
growth rates are decreasing, reflecting the transition from super normal growth to
stable growth.
Let’s calculate the expression to find the present value of dividends during the super
normal growth phase and the stable growth phase:
2.00 × (1 + 0.25) 2.50 × (1 + 0.20 ) 3.00 × (1 + 0.05 )
P0 = + 2
+
0.10 − 0.25 (0.10 − 0.20) (0.10 − 0.05)3
Let’s break down the calculations:

2.00 × 1.25 2.50 × 1.20 3.00 × 1.05

P0 = + +
0.10 − 0.25 (0.10 − 0.20) (0.10 − 0.05)3
2

2.50 3.00 3.15

P0 = + +
−0.15 (−0.10) (−0.05)3
2

Now, let’s perform the calculations:

P0 = -16.67 + 300 + 378

P0 = 661.33

Therefore, the present value of dividends during the super normal growth phase and the
stable growth phase is $661.33.

CHECK YOUR PROGRESS – III

1. Supernormal growth phases are usually characterized by _______.
(a) Slow and steady earnings growth
227
(b) Average growth rates in line with the sector or economy
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Forecasting of Cash Flows-I

NOTES (c) Unsustainable and rapid earnings growth

(d) Declining earnings and stock value
2. Financial analysts assess supernormal growth using _______.
(a) Historical data analysis
(b) Discounted cash flow models and earnings predictions
(c) Industry benchmarking
(d) Technical analysis
3. Supernormal growth can be stimulated by _______.
(a) Stable market conditions
(b) Average product innovation
(c) Market disruptions or significant competitive advantages
(d) Decreased market share
4. Supernormal growth phases are typically long-lasting and sustainable.
(a) True
(b) False
5. International expansion is unlikely to contribute to supernormal growth.
(a) True
(b) False

8.5 LET US SUM UP

• Financial planning and analysis cover all aspects of forecasting.
• This study investigates the strategies used by businesses to anticipate and respond to
various growth scenarios, beginning with typical and abnormal growth rates.
• Cash flow forecasting has several functions in the assessment of corporate value.
• Cash flow forecasting is of great significance in the field of business valuation, as it
plays a crucial part in evaluating a company’s inherent worth and overall financial
well-being.
• Forecasting growth is critical for effective business management.
• Revenue, profitability, and market share increase progressively as the company grows.
• Supernormal growth is rapid and enormous in comparison to industry and economic
averages.
• The Normal Growth Rate is used in financial research to measure a company’s long-term
operational and financial growth.
• GDP, inflation, and interest rates all have an impact on company growth.
• Forecasting cash inflows and outflows ensures that a company has enough liquidity to
meet financial obligations and finance activities.

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8.6 KEYWORDS NOTES
Forecasting: Strategic business and financial decisions necessitate forecasting future
trends and outcomes based on historical data.
Normal Growth Rate: Normal, sustained growth in a company or industry, excluding
exceptional growth or decline.

8.7 REFERENCES AND SUGGESTED ADDITIONAL READING

REFERENCES
1. Brigham, E. F., & Ehrhardt, M. C. (2013). Financial Management: Theory & Practice.
Cengage Learning.
2. Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2015). Essentials of Corporate Finance.
McGraw-Hill Education.
3. Van Horne, J. C., & Wachowicz, J. M. (2014). Fundamentals of Financial Management.
Pearson.
4. Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson.

SUGGESTED ADDITIONAL READING

1. Palepu, K. G., Healy, P. M., & Peek, E. (2013). Business Analysis and Valuation: Using
Financial Statements. Cengage Learning.
2. Penman, S. H. (2012). Financial Statement Analysis and Security Valuation. McGraw-
Hill Education.
3. Copeland, T. E., Koller, T., & Murrin, J. (2016). Valuation: Measuring and Managing
the Value of Companies. Wiley.

8.8 SELF-ASSESSMENT QUESTIONS

1. Which factor is crucial for determining normal growth rate according to the given
content?
(a) Innovations and disruptions
(b) Market demand
(c) Regulatory frameworks
(d) Economic downturns
2. What is a key characteristic of normal growth rate?
(a) Predictability
(b) Market disruption
(c) Short-term focus
(d) Rapid expansion

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NOTES 3. What is the primary purpose of cash flow forecasting in business valuation?
(a) To evaluate historical financial performance
(b) To estimate the current value of future cash flows
(c) To assess market trends and industry patterns
(d) To analyze competitors’ financial statements
4. Why is sustainability a key consideration during supernormal growth?
(a) To disregard long-term risks
(b) To ensure operational strain
(c) To evaluate the duration of the growth phase
(d) To avoid financial challenges
5. How does cash flow forecasting assist in risk management?
(a) By focusing solely on historical financial data
(b) By providing a reactive approach to potential risks
(c) By identifying possible risks and opportunities for strategic adjustments
(d) By forecasting short-term financial performance
6. Which valuation technique relies heavily on cash flow forecasting?
(a) Market comparison approach
(b) Book value method
(c) Discounted Cash Flow (DCF) analysis
(d) Asset-based approach
7. What characterizes a supernormal growth phase in a business?
(a) Slower-than-average growth rate compared to the sector
(b) Sustainable growth driven by consistent market trends
(c) Rapid and unsustainable earnings growth exceeding the sector average
(d) Moderate growth resulting from stable market conditions
8. What are common catalysts for supernormal growth in businesses?
(a) Diversification of product portfolio
(b) Entry into mature markets with stable demand
(c) Significant technological breakthroughs or new product launches
(d) Increased competition leading to slower growth rates
9. How long are supernormal growth phases typically sustained?
(a) Indefinitely, as businesses adapt to the rapid growth rate
(b) Short-lived, due to the inability to sustain rapid growth over time
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(c) Permanently, as long as market conditions remain favorable NOTES
(d) Moderately, until competitors catch up with innovative strategies
10. Why is diversification of revenue streams considered a risk mitigation strategy?
(a) It increases reliance on a single product or service
(b) It exposes the company to segment-specific conditions
(c) It minimizes the need for contingency planning
(d) It reduces sensitivity to market changes

8.9 CHECK YOUR PROGRESS-POSSIBLE ANSWERS

Check Your Progress – I
1. (b)
2. (c)
3. (b)
4. False
5. False
Check Your Progress – II
1. (c)
2. (b)
3. True
4. False
Check Your Progress – III
1. (c)
2. (b)
3. (c)
4. False
5. False

8.10 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (b) 2. (a) 3. (b) 4. (c) 5. (c)
6. (c) 7. (c) 8. (c) 9. (b) 10. (d)

231
 UNIT 9
FORECASTING OF CASH FLOWS-II

STRUCTURE
9.0 Objectives
9.1 Introduction
9.2 Competitive Advantage Period
9.3 Forecasting Cash Flows
9.4 Sensitivity Cashflows Forecasted Under Varying Economic Conditions: Illustration
9.5 Case study on Cash flow analysis
9.6 Let Us Sum Up
9.7 Keywords
9.8 References and Suggested Additional Reading
9.9 Self-Assessment Questions
9.10 Check Your Progress – Possible Answers
9.11 Answers to Self-Assessment Questions

9.0 OBJECTIVES
After reading this unit, you will be able to:
1. explain the impact of the competitive advantage period on supernormal growth
while demonstrating understanding of growth factors.
2. utilize the practical application of normal and supernormal growth rates in
financial analysis, project future cash flows.
3. assess the impact of fluctuations on business forecasts, perform a sensitivity
analysis on projected cash flows.
4. examine the accuracy of forecasting techniques in predicting growth rates,
taking into account both normal and supernormal growth factors, and critically
evaluate their applicability in specific business contexts.
5. demonstrate the practical application of acquired principles, incorporate normal
growth, supernormal growth, and competitive advantage period into growth
projections.

233
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NOTES RECAP OF UNIT 8

A company’s analysis includes a number of critical aspects. A company introduction
provides background information. Management, leadership, and strategy are all
examined. SWOT analyses examine the internal and external factors that influence
strengths, weaknesses, opportunities, and threats. We also delved into the critical role of
growth forecasting in the realm of business valuation, emphasizing the importance of
distinguishing between normal and supernormal growth rates. Growth forecasting serves
as a cornerstone for assessing a company’s future performance and intrinsic value,
guiding strategic decisions and investment strategies. Normal growth rates signify the
sustainable and steady expansion expected within a particular industry or sector, whereas
supernormal growth rates denote extraordinary and unsustainable growth often driven
by innovative breakthroughs or market disruptions. The ability to accurately forecast
these growth rates is paramount for conducting comprehensive business valuations and
making well-informed investment decisions.

9.1 INTRODUCTION
In the field of business valuation, evaluating a company’s long-term performance and
intrinsic worth requires a knowledge of the Competitive Advantage Period (CAP).
The period of time that a business may continue to make supernormal earnings and
retain its competitive advantage is represented by the CAP. This phase is distinguished
by elements like novel discoveries, distinct market positioning, or enhanced operational
efficacy that allow the business to surpass rivals and maintain rapid expansion rates.
For the purpose of precisely projecting the company’s future financial performance and
ascertaining its intrinsic value, cash flow forecasting throughout the CAP is essential.
Predicting the company’s anticipated income, costs, and overall financial performance
during the designated period is necessary in order to forecast cash flows during the
Competitive Advantage Period. A thorough awareness of the competitive environment,
industry dynamics, and primary growth drivers of the organization are necessary for this
approach. Analysts need to evaluate if the firm can continue to generate supernormal
profits at this time and whether its competitive advantages are sustainable. Through the
use of a variety of forecasting methods and financial models, including discounted cash
flow (DCF) analysis, analysts are able to assess the cash flows that the firm will produce
throughout the CAP and assign a value based on those estimates.
Investors, analysts, and other stakeholders may make well-informed choices regarding
the company’s future prospects and investment possibilities by using effective
forecasting during the Competitive Advantage Period. Stakeholders may have a better
understanding of the company’s intrinsic worth and capacity to create long-term
shareholder value by properly projecting cash flows and evaluating the durability of the
company’s competitive advantages. Insights about the company’s growth trajectory, risk
profile, and strategic positioning are also obtained through cash flow forecasts throughout
the CAP, enabling investors to adjust their investment strategies and optimize returns.

9.2 COMPETITIVE ADVANTAGE PERIOD

The term Competitive Advantage Period (CAP) is used in business planning to define the
time when a company can outperform its competitors. The word refers to a time in which
234 a company maintains above-average profitability and market dominance as a result of
unique capabilities, resources, or processes that competitors cannot copy.
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9.2.1 DEFINITION OF COMPETITIVE ADVANTAGE PERIOD (CAP) NOTES

“A company can outperform its competition by building a distinct and long-term strategy
that generates superior customer value during the Competitive Advantage Period.”
Michael Porter.
“Using innovative marketing strategies, brand positioning, and excellent customer
connections, a company can maintain its competitive advantage during the Competitive
Advantage Period.” Philip Kotler
“During the Competitive Advantage Period, intellectual capital, management expertise, and
innovation keep a company ahead of the competition and add value.” Peter Drucker.
“During the Competitive Advantage Period, skills, technology, and relationships give a
company a competitive advantage and sustain profitability”. Amit and Schoemaker.

9.2.2 FACTORS CONTRIBUTING TO CAP

Many factors influence a company’s Competitive Advantage Period (CAP) and ability
to outperform competitors. Understanding these concerns is necessary for strategic
management and long-term success. These components aid CAP:
1. Unique Resources and Capabilities
Patents, proprietary technologies, and trained people enable businesses to
increase their CAP. These resources make competition more difficult.
2. Innovation and Adaptability
Companies that innovate and adapt to market changes may see their CAP rise.
Introducing new products, services, or operational efficiencies can help stay
ahead of the competition.
3. Brand and Reputation
A strong brand and reputation boost CAP. Consumers appreciate established
companies, and a good reputation can shield them from competition.
4. Cost Leadership
Cost leaders can extend their CAP by improving operational efficiency and
leveraging economies of scale. Lower production costs provide a competitive
advantage and long-term profitability.
5. Effective Marketing and Distribution
Marketing and distribution that are effective raise CAP. Strong customer and
distribution partner relationships provide a competitive advantage.
6. Regulatory and Legal Barriers
Industries subject to stringent restrictions or facing legal challenges may have a
lengthier CAP. Compliance difficulty may hinder competitors.
7. Quality and Customer Service
CAP is boosted by excellent client service and continuous product quality.
Customer loyalty and positive word-of-mouth can shield from competitors.
8. Global Expansion and Market Presence
Globally engaged enterprises with the ability to expand into new markets have
a higher CAP. Diversification and global reach help to increase competitiveness. 235
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Forecasting of Cash Flows-II

NOTES 9. Strategic Partnerships and Alliances

Strategic alliances can help the CAP grow. Collaboration with other companies
can help gain access to new markets and resources.
10. Entry Barriers
High entry barriers, such as initial investment, specialized knowledge, or
distribution networks, can extend CAP. These attributes, when controlled
and utilized, provide a firm with a competitive advantage and extend its
outperformance.

9.2.3 EVALUATING AND ESTIMATING CAP

CAP evaluation and estimation necessitates a detailed grasp of the factors that influence
a company’s ability to compete. The procedure is described in detail:
1. Industry Analysis
Examine the industry in which the company operates. Examine the market
structure, competition, and success factors. Longer CAPs are typical of industries
with high entry barriers, few substitutes, and low competition.
2. Barriers to Entry
Determine the barriers to market entry for new entrants. CAP is extended by
high entry barriers such as economies of scale, proprietary technologies, and
brand loyalty.
3. Competitor Analysis
Analyze the competitive landscape to determine competitors’ strengths and
weaknesses. Assess the organization’s resources, capabilities, and strategies to
determine how well-positioned it is in relation to competitors.
4. Resource-Based View (RBV)
Using the Resource-Based View paradigm, evaluate the company’s distinctive
resources and capabilities. Rare, valuable, difficult to copy, and indispensable
resources provide a long-term competitive edge.
5. SWOT Analysis
A SWOT analysis is used to evaluate internal and external factors that affect
the company’s competitive position. Take advantage of possibilities while
minimizing risks.
6. Financial Performance
Examine the company’s finances on a regular basis. Consistent profitability, high
ROI, and large cash flow suggest a higher CAP.
7. Innovation and R&D
Examine the company’s R&D and innovation activities. A longer CAP with an
emphasis on technology and product development is more likely.
8. Legal and Regulatory Environment
Consider the legal and regulatory environment in which the company operates.
Compliance with legislation and industry standards has the potential to stabilize
and grow CAP.
9. Strategic Management
236 Examine the strategic management of the organization. CAP is extended by
effective market positioning, competitive pricing, and strategic collaborations.
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10. Scenario Analysis NOTES
Conduct a scenario study to determine how the company’s competitive position
would evolve in other markets. Prepare for changes in technology, consumer
behavior, and competition.
11. Customer Feedback and Market Perception
Examine market perception as well as client input. A high level of customer
satisfaction suggests a strong competitive position.
12. Global Market Dynamics
Consider global market dynamics, if applicable. A firm with a strong presence
in various areas may have a higher CAP due to economies of scale and global
resources.
13. Adaptability and Flexibility
Examine the company’s ability to respond to market changes. Companies that are
agile and responsive can overcome obstacles and stay ahead of the competition.
14. Long-Term Planning
Examine the long-term plan of the company. Clear long-term strategy assists
businesses in maintaining a competitive advantage.
Analysts and strategists can predict the longevity of a company’s competitive advantage
and make informed investment, strategic planning, and risk management decisions by
carefully examining these factors.

9.2.4 ILLUSTRATION FOR CAP

Let’s look at a forecasting example of Free Cash Flow to Firm (FCFF) and highlight the
Competitive Advantage Period. Assuming a hypothetical corporation ABC Corp. has an
initial operating cash flow (OCF) of Rs. 1 billion, we will assume a competitive advantage
term of 4 years.

9.2.4.1 ASSUMPTIONS
• Competitive Advantage Period: 4 years.
• FCFF is calculated as Operating Cash Flow (OCF)-Capital Expenditures (CapEx).
Table 9.1: Forecasting Example of Free Cash Flow to Firm

Year OCF CapEx FCFF (Rs. Billion) Competitive

(Rs. billion) (Rs. billion) Advantage Period
0 ---- ----- ------ -----
1 1.3 0.6 0.7 4
2 1.35 0.7 0.65 3
3 1.4 0.8 0.6 2
4 1.45 0.9 0.55 1
5 1.5 1.0 0.5 0
For the first four years of our example, we’ll suppose that ABC Corp. enjoys a competitive
edge that enables it to maintain greater operational cash flows. The FCFF column then
shows the Competitive Advantage Period, and following the fourth year, the cash flows 237
begin to decrease as the competitive advantage wanes.
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NOTES Recall that determining the Competitive Advantage Period is difficult and needs a careful
examination of the industry, competitive landscape, and sustainability aspects of the
business. Since this is a simplified approximation, more thorough financial modelling and
analysis would be required in real-world situations. Refinements and adjustments must
be made in light of evolving market conditions and actual performance.

9.2.4.2 COMPETITIVE ADVANTAGE PERIOD FORMULA

Competitive advantage period (CAP) is the time during which a company is expected to
generate returns on incremental investment that exceed its cost of capital. Economic
theory suggests that competitive forces will drive returns down to the cost of capital over
time (and perhaps below it for a period). Said differently, if a company earns above market
required returns, it will attract competitors that will accept lower returns, eventually driving
industry returns lower. The notion of CAP has been around for some time; nonetheless,
not much attention has been paid to it in the valuation literature. The concept of CAP
was formalized by Miller & Modigliani through their seminal work on valuation (1961).
The M&M equation can be summarized as follows:

NOPAT I(R − WACC) CAP

Value = +
WACC WACC (1 + WACC)
Value×WACC (1 + WACC) − NOPAT (1 + WACC) = 1 (R − WACC)CAP
where
NOPAT = net operating profit after tax
WACC = weighted average cost of capital
I = annualized new investment in working and fixed capital
R = rate of return on invested capital
CAP = competitive advantage period
Rearranged, the formula reads:
(Value´WACC − NOPAT)(1 + WACC)
CAP =
1(R − WACC)
These formulas have some shortcomings that make them limit in practice, but they
demonstrate, with clarity, how CAP can be conceptualized in the valuation process.
A company’s CAP is determined by a multitude of factors, both internal and external.
On a company-specific basis, considerations such as industry structure, the company’s
competitive position within that industry, and management strategies define the
length of CAP. The structured competitive analysis framework set out by Michael
Porter can be particularly useful in this assessment. Important external factors include
government regulations and antitrust policies. CAP can also reflect investor psychology
through implied optimism/pessimism regarding a firm’s prospects. We believe that
the key determinants of CAP can be largely captured by a handful of drivers. The first
is a company’s current return on invested capital. Generally speaking, higher ROIC
businesses within an industry are the best positioned competitively (reflecting scale
economies, entry barriers and management execution). As a result, it is often costlier
238
and/or more time consuming for competitors to wrest competitive advantage away
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from high-return companies. Second is the rate of industry change. High returns in a NOTES
rapidly changing sector (e.g., technology) are unlikely to be valued as generously as
high returns in a more prosaic industry (e.g., beverages). The final driver is barriers to
entry. High barriers to entry—or in some businesses, “lock-in” and increasing returns—
are central to appreciating the sustainability of high returns on invested capital.
Note that CAPs are set at the margin by self-interested, motivated, and informed investors.
That is, if an implied CAP is “too short” (too long) for the shares of a given company, astute
investors will purchase (sell) those shares to generate excess returns. Accordingly, changes
in CAP are a critical driver in valuation. Experience shows that CAPs are rarely static, and
are usually in the process of expanding or shrinking.
The Competitive Advantage Period (CAP) is the number of years a company can maintain
its competitive advantage over its rivals. It is a concept often used in valuation models to
estimate the duration of above-average profits that a firm can generate due to a unique
competitive advantage. Let’s go through a numerical problem to illustrate the Competitive
Advantage Period:

9.2.4.3 EXAMPLE I
Let’s illustrate the forecasted cash flows during a Competitive Advantage Period (CAP) for
a company named “ABC Industries.”
Assumptions:
1. The company is expected to have a competitive advantage for a period of
5 years.
2. The initial cash flow for Year 1 (t = 0) is Rs. 1,00,000.
3. The cash flows are expected to grow at a rate of 8% per year during the competitive
advantage period.
4. The discount rate is 10%.
Now, let’s calculate the cash flows for each year during the competitive advantage period
and discount them back to their present value.
For Years 1 to 5:
• Year 1 (t = 0): Rs. 1,00,000 (Initial Cash Flow)
• Year 2 (t = 1): Rs. 1,00,000 × (1 + 0.08) = Rs. 1,08,000
• Year 3 (t = 2): Rs. 1,08,000 × (1 + 0.08) = Rs. 1,16,640
• Year 4 (t = 3): Rs. 1,16,640 × (1 + 0.08) = Rs. 1,25,971.20
• Year 5 (t = 4): Rs. 1,25,971.20 × (1 + 0.08) = Rs. 1,36,048.10

Now, let’s discount each cash flow back to its present value using the discount rate
of 10%:
• Present Value (PV) Year 1 (t = 0): Rs. 1,00,000/(1 + 0.10)0 + = Rs. 1,00,000
• PV Year 2 (t = 1): Rs. 1,08,000/(1 + 0.10)1 ≈ Rs. 98,181.82
• PV Year 3 (t = 2): Rs. 1,16,640/(1 + 0.10)2 ≈ Rs. 93,484.85
• PV Year 4 (t = 3): Rs. 1,25,971.20/(1 + 0.10)3 ≈ Rs. 88,738.95
239
• PV Year 5 (t = 4): Rs. 1,36,048.10/(1 + 0.10)4 ≈ Rs. 83,440.88
UNIT 9
Forecasting of Cash Flows-II

NOTES Finally, let’s sum up the present values of all cash flows to get the total present value:
Total Present Value = Rs. 1,00,000 + Rs. 98,181.82 + Rs. 93,484.85 + Rs. 88,738.95 +
Rs. 83,440.88
Total Present Value ≈ Rs. 4,64,846.50
So, the total present value of cash flows during the competitive advantage period is
approximately Rs. 4,64,846.50.

9.2.4.4 EXAMPLE II
ABC Inc. has recently developed a groundbreaking technology that gives it a competitive
edge over other companies in the industry. The company expects to earn an annual
economic profit of $20 million for the next five years due to this technological advantage.
After five years, the competitive advantage is expected to erode, and the economic profit
will revert to the industry average.
The discount rate is 8%. Calculate the present value of the economic profits during the
Competitive Advantage Period.

Explanation
The present value of economic profits during the Competitive Advantage Period can be
calculated using the formula:
EPt
PV   t1
n

(1  r )t

Where:
• PV is the present value of economic profits,
• EPt is the economic profit in year t.
• r is the discount rate,
• n is the Competitive Advantage Period.

For the given problem, n = 5 years, r = 0.08, and EPt = $20 million for each year.
20 20 20 20 20
PV = 1
+ 2
+ 3
+ 4
+
(1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08) (1 + 0.08)5
Now, let’s perform the calculations:

20 20 20 20 20
PV = 1
+ 2
+ 3
+ 4
+
(1.08) (1.08) (1.08) (1.08) (1.08)5

PV ≈ $18.52 + $17.13 + $15.81 + $14.55 + 13.44

PV ≈ $79.45

Therefore, the present value of economic profits during the Competitive Advantage
Period is approximately $79.45 million. This represents the estimated total value of the
240 economic profits that the company expects to earn during the five-year period when it
has a competitive advantage.
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CHECK YOUR PROGRESS – I NOTES
1. What characterizes a business experiencing supernormal growth?
(a) Steady market expansion
(b) Below-average growth rate
(c) Sustainable innovations
(d) Faster-than-average growth driven by breakthroughs
2. How do financial analysts evaluate supernormal growth?
(a) Using historical performance
(b) Ignoring earnings projections
(c) Utilizing discounted cash flow models and earnings projections
(d) Relying solely on market trends
3. What is a potential risk associated with supernormal growth?
(a) Decreased rivalry
(b) Market saturation
(c) Limited competition
(d) Stability in original advantages
4. Supernormal growth is usually sustained over the long term due to consistent
market trends.
(a) True
(b) False
5. Operational scalability is not necessary during periods of rapid expansion.
(a) True
(b) False

9.3 FORECASTING CASH FLOWS

Cash flow forecasting is required for business financial planning in order to predict and
manage liquidity. Cash flow forecasting is the process of anticipating cash flows over a
specific time period. This strategy assists companies in making decisions, budgeting, and
remaining financially healthy.

9.3.1 OVERVIEW OF CASH FLOW FORECASTING

Forecasting cash flow timing and amounts provides an organization with a complete
financial picture. Forecasting ensures that businesses have enough cash to cover
operations, debt, and unforeseen expenses. It guarantees that adequate cash is on hand
to run everyday activities in order to avoid cash shortages. Cash flow estimates assist
organizations in budgeting and planning. These projections inform resource allocation
and financial objectives. Organizations can better distribute funds, prioritize initiatives, 241
and make strategic decisions by projecting financial demands. Cash flow projections
UNIT 9
Forecasting of Cash Flows-II

NOTES assist financial decisions. Cash flow can be used by businesses to analyze the viability
of new projects, expansions, and investments. Effective cash flow forecasting assists in
the management of supplier and creditor relationships. Based on projected cash flows,
businesses can negotiate better credit terms. Anticipating cash inflows and outflows
assists businesses in detecting and mitigating financial hazards. It aids businesses in
weathering economic downturns.

9.3.2 FORECASTING OPERATING CASHFLOWS FOR

BUSINESS VALUATION
Forecasting operating cash flows is a critical step in valuation analysis, providing insights
into a company’s ability to generate cash from its core business operations. Here’s a
detailed guide on how to forecast operating cash flows for valuation purposes:
1. Understand the Basics
Definition: Operating cash flow (OCF) represents the cash generated or used by
a company’s core operating activities.
Components: OCF includes net income, adjustments for non-cash items, and
changes in working capital.
2. Review Financial Statements
Income Statement: Start with the company’s income statement to identify net
income. Net income is the starting point for operating cash flow.
Cash Flow Statement: Refer to the cash flow statement to analyze how cash is
generated or used in operating activities. Focus on the operating activities section.
3. Adjustments to Net Income
Non-Cash Expenses: Add back non-cash expenses such as depreciation and
amortization to net income.
Non-Operating Items: Exclude non-operating items like gains or losses on the
sale of assets.
Changes in Working Capital: Adjust for changes in working capital, including
accounts receivable, inventory, and accounts payable.
4. Calculate Operating Cash Flow
Operating Cash Flow Formula:
OCF = Net Income + Non − Cash Expenses + Changes in WorkingCapital
+ Non − Operating Items
5. Analyzing Working Capital Changes
Accounts Receivable (AR): An increase in AR reduces cash flow, while a decrease
increases it.
Inventory: An increase in inventory reduces cash flow, while a decrease increases it.
Accounts Payable (AP): An increase in AP increases cash flow, while a decrease
reduces it.
6. Project Future Financials
Revenue and Expense Projections: Forecast future revenues and operating
expenses. Consider industry trends, market conditions, and company-specific
242 factors.
Margins: Analyze historical profit margins and project future changes.
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Working Capital Changes: Forecast changes in working capital based on expected NOTES
sales growth and operational efficiency improvements.
7. Discount Future Cash Flows
Discount Rate: Apply a discount rate to future cash flows to bring them to their
present value. The discount rate represents the cost of capital and risk associated
with the investment.
8. Sensitivity Analysis
Scenario Analysis: Conduct sensitivity analysis by adjusting key assumptions (e.g.,
revenue growth, margins) to understand the impact on cash flow projections.
Risk Factors: Consider potential risks that could impact cash flows and adjust
projections accordingly.
9. Use Financial Models
DCF Model: Utilize a discounted cash flow (DCF) model for valuation, incorporating
the forecasted operating cash flows and discounting them to their present value.
Free Cash Flow to Firm (FCFF): For firm valuation, consider using FCFF, which
includes tax effects and capital expenditures.
10. Periodic Review and Update
Regular Review: Periodically review and update the cash flow forecast based on
actual financial results and changes in market conditions.
Adjust Projections: Modify projections as necessary to reflect new information,
changing business conditions, or strategic shifts.
By following these steps, a comprehensive forecast of operating cash flows for valuation
purposes can be created, providing a solid foundation for assessing the intrinsic value
of a company. For calculation of intrinsic value Free Cash Flows for the firm (FCFF) are
calculated as follows:
FCFF = EBIT(1 − T) + Depreciation − Δ Capital Investment
− Δ Working Capital Investment

9.3.4 ILLUSTRATION
9.3.4.1 PROBLEM
Let’s look at a numerical example of how to project cash flows for XYZ Corp., over a three-
year period. We will take into account operational cash flows (OCF) and include estimates for
changes in working capital, revenue growth, spending, and capital expenditures.

ASSUMPTIONS
YEAR 0 (HISTORICAL)
• Revenue: Rs. 80 million
• Depreciation: Rs. 20 million

WORKING CAPITAL CHANGES (YEAR 0 TO YEAR 1)

• Accounts receivable increased by Rs. 15 million.
243
• Inventory increased by Rs. 8 million.
• Accounts payable increased by Rs. 5 million.
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Forecasting of Cash Flows-II

NOTES FUTURE PROJECTIONS (YEARS 1 TO 3)

• Annual revenue growth: 10%
• Operating expenses as a percentage of revenue: 60%
• Capital expenditures: Rs. 25 million per year
• Tax Rate: 30%
Calculations:
Year 1:
Forecasted Revenue = Rs. 80 million × (1 + 0.10) = Rs. 88 million
Forecasted Operating Expenses = Rs. 88 million × 0.60 = Rs.52. 8 million
Estimated Capital Expenditures = Rs. 25 million
Incremental Working Capital = (15 + 8 − 5) million
FCFF = EBIT(1 − T) + Dep. − ΔCapex − ΔWC
Here
EBIT = Revenue − Op. exp = 88 − 52.8 = 35.2 million
ECFF = 35.2(1 − 0.30) + 20 − 25 − 18 = 1.64 million
Perform similar calculations for Years 2 and 3.
Assuming a discount rate of 10%, calculate the present value of the net cash flows for each
year and the total present value of cash flows.

9.3.4.2 PROBLEM
ABC Ltd., an Indian manufacturing company, is preparing a cash flow forecast for the next
three years. The company anticipates the following cash inflows and outflows:
Year 1:
Cash inflows: I50,00,000
Cash outflows: I35,00,000
Year 2:
Cash inflows: I60,00,000
Cash outflows: I40,00,000
Year 3:
Cash inflows: I70,00,000
Cash outflows: I45,00,000

EXPLANATION
The present value (PV) of future cash flows can be calculated using the formula:
CF
PV =
(1 + r )t
Where:
• PV is the present value of cash flows,
• CF is the cash flow in the future period,
244 • r is the discount rate,
• t is the time period.
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For each year, calculate the present value of cash inflow and cash outflows separately NOTES
and then find the net cash flow. Finally, sum up the present value to find the total present
value of cash flows.
Year 1:
I 50,00,000
PVInflows =
(1 + 0.10)1
I35,00,000
PVOutflows =
(1 + 0.10)1

PVNet PVInflows − PVOutflows

=

Year 2:
I60,00,000
PVInflows =
(1 + 0.10)2
I 40,00,000
PVOutflows =
(1 + 0.10)2

PVNet PVInflows − PVOutflows

=

Year 3:
I70,00,000
PVInflows =
(1 + 0.10)3
I 40,00,000
PVOutflows =
(1 + 0.10)3

PVNet PVInflows − PVOutflows

=

Total Present Value:

Total PV = PVNet, Year 1 + PVNet, Year 2 + PVNet, Year 3

Year 1:
I 50,00,000 I 50,00,000
PVInflows
= = ≈ I 45,45,454.55
(1 + 0.10)1 1.10
I 35,00,000 I35,00,000
PVOutflows
= = ≈ I31,81,818.18
(1 + 0.10)1 1.10
PVNet = PVInflows – PVOulows  ` 13, 63, 636.37

Year 2:
I 60,00,000 I60,00,000
PVInflows
= = ≈ I 49,58,677.69 245
(1 + 0.10)2 1.21
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Forecasting of Cash Flows-II

NOTES I 40,00,000 I 40,00,000

PVOutflows
= = ≈ I33,05,785.12
(1 + 0.10)2 1.21

PVNet = PVInflows – PVOulows  I 16, 52, 892.57

Year 3:
I 70,00,000 I70,00,000
PVInflows
= = ≈ I 52,56,076.05
(1 + 0.10)3 1.331

I 40,00,000 I 40,00,000
PVOutflows
= = ≈ I33,76,416.29
(1 + 0.10)3 1.331

PVNet = PVInflows – PVOulows  I 18, 79, 659.76

Total Present Value:

Total PV = PVNet, Year 1 + PVNet, Year 2 + PVNet, Year 3

Total PV ≈ 13,63,636.37 + 16,52,892.57 + 18,79,659.76

Total PV ≈ 48,96,188.70
Therefore, the total present value of cash flows over the three-year period is approximately
D48,96,188.70 in Indian rupees.

CHECK YOUR PROGRESS – II

1. What is the primary purpose of cash flow forecasting for businesses?
(a) Predicting stock market trends
(b) Anticipating changes in interest rates
(c) Managing liquidity and predicting cash flows
(d) Evaluating long-term investments
2. Which section of the Cash Flow Statement includes cash transactions related to a
company’s core business?
(a) Operating Activities
(b) Financing Activities
(c) Investing Activities
(d) Net Cash Flow
3. Why is cash flow forecasting essential for risk management in businesses?
(a) To avoid budgeting and planning
(b) To ignore the impact on liquidity
(c) To disregard historical cash flow data
246
(d) To identify and manage financial risks
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4. The Operating Activities section of the Cash Flow Statement includes cash NOTES
transactions related to long-term assets and investments.
(a) True
(b) False
5. The Discounted Cash Flow (DCF) Method does not consider the time value of money
in projecting future cash flows.
(a) True
(b) False

9.4 SENSITIVITY CASHFLOWS FORECASTED UNDER VARYING

ECONOMIC CONDITIONS: ILLUSTRATION
Sensitivity analysis evaluates how different factors affect financial results, which helps
identify decision-making weaknesses and uncertainties. This approach demonstrates the
resilience of the financial model and strategy by simulating changes in key variables and
assessing how those changes affect financial indicators.
Financial results are influenced by interest rates, market circumstances, commodity
prices, and exchange rates. Sensitivity analysis is a tool that financial analysts and
decision-makers may use to measure the risks and opportunities associated with various
situations.
A sensitivity analysis shows how interest rates impact a company’s cash flows or net
present value. Changing variables within a predetermined range allows analysts to take
advantage of favorable situations or prevent hazards. Sensitivity analysis is necessary in
light of market volatility and economic downturns. For financial professionals, it improves
risk management, decision-making, and long-term planning. Financial decision-making
is dynamic and complex, but sensitivity analysis may help by making possible outcomes
clearer.
Let’s look at an example of XYZ Tech Solutions’ cash flow forecasting under various
economic scenarios. Over a three-year period, we will examine three different
economic scenarios: a baseline scenario, a recessionary scenario, and an expansionary
scenario.

9.4.1 ASSUMPTIONS
BASELINE SCENARIO (MOST LIKELY)
• Annual revenue growth: 8%
• Operating expenses as a percentage of revenue: 65%
• Capital expenditures: Rs. 30 million per year
• Depreciation: Assumed to be Rs. 30 million per year
• Initial revenue: Rs. 100 million

RECESSIONARY SCENARIO (ADVERSE ECONOMIC CONDITIONS)

• Annual revenue growth: –5% (negative growth) 247
• Operating expenses as a percentage of revenue: 70%
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NOTES • Capital expenditures: Rs. 25 million per year

• Depreciation: Assumed to be Rs. 25 million per year
• Initial revenue: Rs. 100 million

EXPANSIONARY SCENARIO (FAVORABLE ECONOMIC CONDITIONS)

• Annual revenue growth: 12%
• Operating expenses as a percentage of revenue: 60%
• Capital expenditures: Rs. 35 million per year
• Depreciation: Assumed to be Rs. 35 million per year
• Initial revenue: Rs. 100 million

DISCOUNT RATE
• The discount rate used for present value calculations is 9%.
Let’s assume the changes in working capital for each year are as follows:
• Year 1: Rs. 10 million
• Year 2: Rs. 15 million
• Year 3: Rs. 20 million
Calculations for Year 1:
OCFbaseline , year 1 = (Revenue´ (1 + Revenue Growth)
´ (1 - Operating Expenses as a Percentage of Revenue) + Depreciation)
- (Capital Expenditures + Changes in Working Capital)

OCFbaseline , year 1 = (Rs. 100 million´ (1 + 0.08)´ (1 - 0.65) + Rs. 30 million)

- (Rs. 30 million + Rs. 10 million) = Rs. 27.8 million

OCFrecession , year 1 = (Rs.100 million´(1 - 0.05)´(1 - 0.70) + Rs. 25 million)

- (Rs. 25 million + Rs.10 million) = 18.5 million

OCFexpansion , year 1 = (Rs.100 million´(1 + 0.12)´(1 - 0.60) + Rs. 35 million)

- (Rs. 35 million + Rs.10 million) = 34.8 million

Calculations for Year 2:

OCFbaseline , year 2 = (Rs. 100 million ´(1 + 0.08)2 ´(1 - 0.65) + Rs. 30 million)
- (Rs. 30 million + Rs. 15 million) = Rs. 25.824 million

OCFrecession , year 2 = (Rs. 100 million ´ (1 - 0.05)2 ´ (1 - 0.70) + Rs. 25 million)

- (Rs. 25 million + Rs. 15 million) = Rs. 12.075 million

OCFexpansion , year 2 = (Rs.100 million´ (1 + 0.12)2 ´(1 - 0.60) + Rs. 35 million)

248 - (Rs. 35 million + Rs.15 million) = Rs. 35.176 million
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Calculations for Year 3: NOTES
3
OCFbaseline , year 3 = (Rs. 100 million ´ (1 + 0.08) ´(1 - 0.65) + Rs. 30 million)
- (Rs. 30 million + Rs. 20 million) = Rs. 24.09032 million

OCFrecession , year 3 = (Rs.100 million ´(1 - 0.05)3 ´(1 - 0.70) + Rs. 25 million)
- (Rs. 25 million + Rs. 20 million) = Rs. 5.721 million

OCFexpansion , year 3 = (Rs.100 million ´ (1 + 0.12)3 ´(1 - 0.60) + Rs. 35 million)

- (Rs. 35 million + Rs. 20 million) = Rs. 36.197 million

The Operating Cash Flow for 3 years under various economic scenarios is represented
by these numbers. The findings demonstrate how a company’s capacity to produce cash
from its activities is impacted by prevailing economic conditions.

CHECK YOUR PROGRESS – III

1. What is the primary purpose of sensitivity analysis in finance?
(a) Predicting future market trends
(b) Assessing vulnerabilities and uncertainties in decision-making
(c) Simulating historical financial data
(d) Analyzing current market conditions
2. Which of the following is NOT a goal of sensitivity analysis in finance?
(a) Historical Data Analysis
(b) Decision Optimization
(c) Risk Mitigation
(d) Enhanced Communication
3. What does the strategy of “Flexible Cost Structures” involve?
(a) Increasing costs regardless of market changes.
(b) Adapting cost structures to revenue and market changes.
(c) Maintaining fixed costs to ensure stability.
(d) Ignoring adverse market conditions.
4. True or False: Sensitivity analysis is particularly useful in stable and predictable
economic environments.
(a) True
(b) False
5. True or False: Scenario planning involves developing only the best-case scenarios to
optimize decision-making.
(a) True 249
(b) False
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NOTES 9.5 CASE STUDY ON CASH FLOW ANALYSIS

CASE STUDY: CASH FLOW ANALYSIS OF HUNT CORPORATION
HUNT Corporation, a dynamic player in the technology sector, recognized the need for
comprehensive financial scrutiny to navigate uncertainties and fortify its fiscal foundation.
This case study delves into the Operating Cash Flow (OCF) forecasting journey undertaken
by HUNT Corporation to assess short-term liquidity, optimize operational efficiency, and
enhance strategic planning.

9.5.1 METHODOLOGY
HISTORICAL DATA ANALYSIS
• HUNT Corporation initiated the process with a meticulous examination of historical
financial data.
• Constructed a cash flow statement, dissecting operating, investing, and financing
activities.

RATIO ANALYSIS FOR SHORT-TERM SOLVENCY

• Applied ratio analysis, including metrics like the current ratio and quick ratio.
• Gained insights into short-term solvency, directing focus towards enhancing
liquidity.

GRANULAR EVALUATION OF WORKING CAPITAL

• Conducted a granular evaluation of working capital components.
• Identified avenues for improving inventory turnover and receivables collection
efficiency.

CASH FLOW FORECASTING

• Utilized cash flow forecasting to create scenarios predicting potential challenges
and facilitating proactive risk-mitigation strategies.
Assumed annual revenue growth, operating expenses as a percentage of revenue, tax
rates, and capital expenditures.

SCENARIO-BASED OCF CALCULATIONS

OCFYear 1 = (Revenue × (1 + Growth Rate) × (1 - Operating Expenses as a percentage
of revenue) + Depreciation) - (Capital Expenditures + Working Capital Changes)

OCFYear 2 = Calculate OCF using Year 1 insights and assumptions

OCFYear 3 = Calculate OCF using Year 2 insights and assumptions

9.5.2 OUTCOMES AND STRATEGIES USED

9.5.2.1 IMPROVING WORKING CAPITAL UTILIZATION
250
• Adapted tactics based on knowledge to maximize working capital.
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9.5.2.2 GETTING GOOD TERMS NEGOTIATED NOTES
• Improved cash flow dynamics by negotiating advantageous terms with suppliers.

9.5.2.3 DEVELOPMENTS IN TECHNOLOGY

• Adopted technology innovations to improve operational effectiveness, resulting in
considerable cost reductions.

9.5.2.4 RESULTS
• Enhanced Liquidity: Increasing cash availability was the outcome of improved
liquidity.
• Cost reductions: Significant cost reductions were achieved through operational
changes.
• Empowered Management: The management team’s judgements on strategic
investments and expansion initiatives were well-informed due to their extensive
expertise.
In conclusion, Hunt Corporation’s experience with operational cash flow forecasting serves
as a reminder of the vital role that financial analysis plays in a company’s ability to navigate
uncertainty and strategically position itself for long-term development in the quickly
evolving technology industry. HUNT Corporation was able to attain financial resilience
and strategic advantage through the combination of proactive cash flow forecasting, ratio
analysis, and strategy execution.

9.5.2.5 QUESTIONS
1. How did HUNT Corporation use historical financial data and ratio analysis,
including metrics like the current ratio and quick ratio, to assess short-term
solvency and enhance liquidity?
2. In what ways did the granular evaluation of working capital components
contribute to HUNT Corporation’s identification of avenues for improving
inventory turnover and receivables collection efficiency?
3. Elaborate on the scenarios created by HUNT Corporation through cash flow
forecasting, and how did these scenarios aid in predicting potential challenges
and facilitating proactive risk-mitigation strategies?

9.6 LET US SUM UP

• The Competitive Advantage Period is examined in terms of its role in maintaining a
distinct market position.
• Following that, the importance of cash flow forecasting in the contexts of financial
planning and risk management is discussed.
• The final section describes sensitivity analysis, which determines the potential impact
of variable changes on financial outcomes.
• The material provides readers with a comprehensive understanding of financial analysis
and forecasting, assisting them in navigating ambiguities, making informed decisions, 251
and establishing organizational fortitude in volatile market environments.
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NOTES 9.7 KEYWORDS

Competitive Advantage: Characteristics or assets that give a company a competitive
advantage in the market.
Cash Flow Statements: Cash flow records are critical for assessing a company’s liquidity
and financial health.
Sensitivity Analysis: Identifying risks and uncertainties by analyzing how variables or
assumptions affect financial outcomes.
Risk Mitigation: Risk mitigation strategies for business operations and financial performance.

9.8 REFERENCES AND SUGGESTED ADDITIONAL READING

REFERENCES
1. Block, S. B., & Hirt, G. A. (2017). Foundations of Financial Management. McGraw-
Hill Education.
2. Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance.
McGraw-Hill Education.
3. Brigham, E. F., & Houston, J. F. (2018). Fundamentals of Financial Management.
Cengage Learning.

SUGGESTED ADDITIONAL READING

1. Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining
the Value of Any Asset. Wiley.
2. Brealey, R. A., Myers, S. C., & Marcus, A. J. (2017). Fundamentals of Corporate
Finance. McGraw-Hill Education.
3. Pike, R., Neale, B., & Linsley, P. (2006). Corporate Finance and Investment: Decisions
and Strategies. Pearson.

9.9 SELF-ASSESSMENT QUESTIONS

1. What does the Competitive Advantage Period (CAP) represent in business
valuation?
(a) The period during which a company earns normal profits
(b) The duration in which a company experiences rapid growth rate
(c) The time frame during which a company maintains its competitive edge
(d) The phase when a company faces declining revenues
2. Why is cash flow forecasting crucial during the Competitive Advantage Period?
(a) To predict historical financial performance
(b) To determine short-term profitability
(c) To assess long-term growth potential
252 (d) To evaluate current market conditions
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3. Which factor contributes to a company’s Competitive Advantage Period (CAP)? NOTES
(a) Operational strain
(b) Market saturation
(c) Regulatory compliance
(d) Unique resources and capabilities
4. What factors are important to consider when forecasting cash flows during the CAP?
(a) Industry dynamics and competitive landscape
(b) Short-term economic trends
(c) Current market share
(d) Historical financial data
5. How does the Percentage of Sales Method project cash flows?
(a) Based on historical patterns
(b) As a percentage of operating activities
(c) By analyzing direct cash transactions
(d) As a percentage of sales
6. What is the purpose of the Discounted Cash Flow (DCF) Method in cash flow
forecasting?
(a) Extrapolating historical data
(b) Adjusting for non-cash items
(c) Converting forecasted cash flows to present value
(d) Aligning accounting net income with operating cash flows
7. How does the Rolling Cash Flow Forecast differ from fixed budgets?
(a) It remains static regardless of new data.
(b) It adjusts projections based on changing conditions.
(c) It focuses only on historical cash flow patterns.
(d) It disregards the time value of money.
8. How does sensitivity analysis assist in strategic management?
(a) By predicting stock market trends
(b) By simplifying complex information
(c) By providing long-term financial planning insights
(d) By minimizing external influences
9. What is the significance of identifying key variables in sensitivity analysis?
(a) It increases model complexity.
253
(b) It reduces the need for scenario analysis.
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NOTES (c) It helps determine how external factors influence financial metrics.
(d) It eliminates the need for stakeholder input.
10. What is the first step in forecasting operating cash flows for valuation purposes?
(a) Reviewing the balance sheet
(b) Analyzing the cash flow statement
(c) Understanding the income statement
(d) Examining the statement of retained earnings

9.10 CHECK YOUR PROGRESS-POSSIBLE ANSWERS

Check Your Progress – I
1. (d)
2. (c)
3. (b)
4. False
5. False
Check Your Progress – II
1. (c)
2. (a)
3. (d)
4. False
5. False
Check Your Progress – III
1. (b)
2. (a)
3. (b)
4. False
5. False

9.11 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (c) 3. (d) 4. (a) 5. (d)
6. (c) 7. (b) 8. (c) 9. (c) 10. (c)

254
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STRUCTURE
10.0 Objectives
10.1 Introduction
10.2 Risk-Return Relationship
10.3 Risk-Free Return, Market Return and CAPM
10.4 Concept of (β)
10.5 Cost of Equity
10.6 Cost of Debt
10.7 Weighted Average Cost of Capital (WACC)
10.8 Distinction between the discounting rate for valuation of a public company vis-a-vis
private equity investment
10.9 Let Us Sum Up
10.10 Keywords
10.11 References and Suggested Additional Readings
10.12 Self-Assessment Questions
10.13 Check Your Progress–Possible Answers
10.14 Answers to Self-Assessment Questions

10.0 OBJECTIVES
After reading this unit, you will be able to:
1. understand the concepts, effects of risk, and return on investment decisions.
2. interpret the risk associated with an asset’s required rate of return, based on
CAPM.
3. examine the concept of Beta in calculating the sensitivity of a security to market
movements.
4. apply the different methods of calculating the cost of capital of a firm from
different sources.

255
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NOTES RECAP OF CHAPTER 9

In the previous chapter, we learned why and how to estimate an organization’s future
cash flows. The chapter talked about how normal and supernormal growth rates are
important because they show how well a company is doing financially. The cash flow
growth rate shows how much a company’s cash flow has changed over a certain amount
of time, usually a year. Students also learned about sensitivity analysis, a way to find
out how sensitive one’s financial plans are to changes in key assumptions, inputs,
or factors.

10.1 INTRODUCTION
A financial indicator called the discount rate, often referred to as the discount factor or
discounting rate, is used to determine the present value of future cash flows or a future
sum of money. It is a crucial part of discounted cash flow (DCF) analysis, a popular finance
valuation technique used to estimate the present value of a future lump amount or stream
of cash flows.
Here are key aspects of the concept of the discount rate:
1. Time Value of Money: The discount rate reflects the time value of money,
acknowledging that the value of money changes over time. A sum of money
received today is considered more valuable than the same amount received in
the future due to its earning potential and risk factors.
2. Present Value Calculation: The discount rate is used in present value calculations
to convert future cash flows or sums into their current value. The formula for
calculating present value (\(PV\)) is:

Future Value
PV =
(1 + Discount Rate )n
Where:
−Future Value is the future cash flow or sum of money.
−n is the number of periods into the future.
3. Risk and Opportunity Cost: The risk attached to the future cash flows is reflected
in the discount rate. Usually, investors utilise a discount rate that accounts for
their needed rate of return, which is determined by a number of variables
including the investment’s risk and the opportunity cost of making a different
investment.
4. Determining Investment Viability: A greater discount rate indicates a higher
necessary rate of return when assessing investment prospects or projects.
Investments or projects with a positive net present value (NPV) are deemed
feasible at the selected discount rate, whereas those with a negative NPV might
not be as appealing.
5. Discount Rate Components: The risk-free rate, which is usually the rate on
government bonds, a risk premium, which represents the extra return needed
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to take on risk, and other project-or investment-specific elements can all be NOTES
included in the discount rate.
6. Adjustment for Inflation: When figuring up the discount rate, inflation is
frequently taken into account. The actual discount rate (adjusted for inflation)
and the anticipated inflation rate are both included in the nominal discount rate.
To sum up, the discount rate is an important component of financial valuation
since it offers a way to evaluate the present value of future cash flows or
amounts of money while accounting for risks and the time value of money.
A number of variables, including the investment’s nature, current interest
rates, and the investor’s or organization’s risk tolerance, will determine the
right discount rate.

10.1.1 IMPORTANCE OF DISCOUNTING RATE

The discounting rate, often referred to as the required rate of return or the discount rate,
is crucial to the value of a firm for several reasons.
• Time Value of Money: The discounting rate takes into account the idea that a quantity
of money today is worth more than the same amount in the future. By putting
future cash flows at their present value, it offers a fair basis for comparison.
• Risk Adjustment: To account for the level of risk associated with the investment,
a risk premium is added to the discount rate. Businesses that are deemed to be
riskier will also have higher discount rates, which will impact their valuation.
• Opportunity Cost: The discount rate is a representation of the cost of capital
investment in a particular business. Reflecting the possible return on different
investments with same risk, it helps investors and businesses make decisions.
• Assessing Viability: The discount rate plays a major role in determining how viable
a company or investment is. If the discounted cash flows indicate a higher return
than the initial investment, the project is considered viable.
• Comparison of Investments: A uniform discounting rate provides a standard
method for evaluating the value of each investment, allowing for the comparison
of different investments. This is crucial for investors who want to allocate cash
wisely.
• Sensitivity Analysis: Stakeholders can do sensitivity analysis and understand the
possible impacts of rate changes on valuation by altering the discount rate. This
study is essential to assess the valuation model’s robustness.
• Reflecting Market Conditions: The discount rate considers interest rates and
current market conditions to ensure that the value is consistent with the prevailing
economic conditions.
• Long-Term Planning: One typical stage in company evaluation is projecting future
cash flows. By discounting these cash flows, the valuation takes into consideration
the company’s long-term survival and financial health.
In conclusion, the discounting rate—a fundamental element of business valuation—
integrates time, risk, opportunity cost, and market conditions. It provides a comprehensive
and useful analysis of future cash flow present value, helping businesses, investors, and
analysts make educated financial decisions. 257
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NOTES Let us now discuss the factors that affect the discount rate.

10.1.2 FACTORS AFFECTING THE DISCOUNT RATE

Many factors affect the required rate of return, which is also known as the cost of capital
or the discount rate in financial analysis. These components work together to illustrate the
possible expense and risk of an investment. Important factors that impact the discount
rate include the following:

RISK-FREE RATE
The discount rate is derived from the risk-free rate, which is often based on government
bonds such as US Treasuries. Being able to demonstrate the rate of return that an investor
can get without incurring any risks makes it a useful benchmark for assessing other
investments.

PREMIUM FOR MARKET RISK

The market risk premium accounts for the additional return that investors need to take
on for taking on the risk of investing in the stock market as opposed to risk-free assets.
It is the past performance of the market less the risk-free rate.

SYSTEMATIC RISK, OR BETA

Beta is a measure of how sensitive an investment’s returns are to fluctuations in the
market. A beta greater than one indicates more volatility relative to the market, whereas
a beta less than one indicates reduced volatility. A higher beta results in a higher discount
rate, offsetting the increase in systematic risk.
Risk Specific to the Company: Business risk, which encompasses factors including market
share, industry competition, and management calibre, affects the discount rate.
The perceived risk associated with a particular organisation increases with the discount rate.

COST OF DEBT
For leveraged businesses, the overall discount rate is impacted by the cost of debt. It includes
the interest rate on debt and signifies the default risk. Alongside the cost of debt comes an
increase in both the total discount rate and the weighted average cost of capital (WACC).

COST OF EQUITY
The cost of equity reflects the return that equity investors desire. Factors like dividends,
earnings growth, and investor expectations all have an impact on it. A higher cost of equity
results in a larger discount rate.

PREMIUM SIZE
A size premium is occasionally added to the discount rate to account for the likelihood
that smaller companies are viewed as riskier. The size premium offsets the additional risk
associated with investing in smaller, less liquid companies.
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COUNTRY RISK NOTES
Additional risk considerations that multinational firms may face in their host nations include,
but are not limited to, political unpredictability, currency risk, and economic challenges.
The discount rate accounts for nation risk in order to account for these uncertainties.

ECONOMIC CONDITIONS
A multitude of economic factors, including inflation, interest rate movements, and overall
economic stability, have an impact on the discount rate. Both the risk-free rate and the
discount rate may be impacted by changes in the economy.

INDUSTRY RISK
A higher discount rate to account for the uncertainty in these domains can be justified for
companies with higher inherent risk, such as biotechnology and technology.

BUSINESS RISK
The competitive landscape, future growth potential, and the firm model’s perceived
level of risk all affect the discount rate. Businesses with stable cash flows and established
industry sectors may be eligible for reduced discount rates.

TIME HORIZON
The time horizon of the investment has an impact on the discount rate. Longer-term
investments may have higher levels of uncertainty, which calls for a higher discount rate.
To find an appropriate discount rate for a certain investment or valuation model, several
factors must be balanced. Financial analysts often use techniques such as the weighted
average cost of capital (WACC) and the capital asset pricing model (CAPM) to calculate
the discount rate based on these factors. By altering the discount rate in reaction to
changes in these factors, an accurate and dynamic assessment of the investment’s risk
and potential return is made feasible.
Moving further, let us now understand the two main components of discounting rate.

10.1.3 COMPONENTS OF DISCOUNTING RATE

The required rate of return or discounting rate consists of two main components: the
risk-free rate and the risk premium. These components help investors and analysts
assess the return they should demand for taking on investment risk. Let’s delve into each
component:

RISK-FREE RATE
• The risk-free rate serves as the baseline return that an investor would expect with
no risk of loss. It is often based on the yield of government bonds, particularly
long-term securities like U.S. Treasuries.
• This rate reflects the time value of money and provides a foundation for calculating
the opportunity cost of investing in a risky asset.
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NOTES RISK PREMIUM

• The risk premium represents the additional return investors require to compensate for
the risk associated with a particular investment. It reflects the investor’s expectation
of a higher return for taking on additional risk beyond the risk-free rate.
• The risk premium can vary based on factors such as the volatility of the investment,
economic conditions, industry-specific risks, and the perceived creditworthiness of
the issuer (in the case of bonds).
• The required rate of return (RRR) is then calculated by adding the risk premium to
the risk-free rate:

Required Rate of Return (RRR) = Risk − Free Rate + Risk Premium

The risk premium can further be categorised into different types:
• Equity Risk Premium (ERP): This is the additional return required for investing
in equities compared to risk-free assets. It reflects the extra risk associated with
owning stocks.
• Credit Risk Premium: For bonds and debt instruments, the credit risk premium
compensates investors for the risk of default. Higher-risk bonds typically have
higher credit risk premiums.
• Country Risk Premium: In the case of multinational investments, the country risk
premium compensates for the additional risk associated with the economic and
political conditions of a specific country.
• Industry-Specific Risk Premium: Certain industries may carry higher inherent risks,
and investors may demand an additional premium for investing in those sectors.
The sum of the risk-free rate and the risk premium provide a comprehensive gauge of the
return that investors want to compensate for the risk involved in a certain transaction.
The notion is essential in financial valuation and investment decision-making, commonly
used in models such as the Capital Asset Pricing Model (CAPM) to calculate the necessary
rate of return for stocks.

10.2 RISK-RETURN RELATIONSHIP

In the last part, we explored the basic principles of risk and return. Now, let’s examine the
complex correlation between the level of risk and the corresponding level of return that
is linked to securities.
It is essential to recognise that certain investments naturally have a greater likelihood
of experiencing losses compared to others. Hence, it is crucial to possess a detailed
comprehension of the intricate relationship between risk and return before considering
any investing plan. Achieving our financial objectives requires us to carefully balance
these two aspects. While certain individuals may willingly accept more risks in order to
get larger benefits, others may prioritise a consistent and low-risk source of income.
The relationship between risk and return is positively correlated; choosing to take on
increased risk might potentially lead to bigger returns, while a preference for lesser risk
may result in more moderate returns. Nevertheless, it is crucial to acknowledge that
external financial difficulties can sometimes disturb this balance. During times of financial
260
hardship, investors who have put money into a firm that is losing money may be at danger
of losing the money they have invested.
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The risk and return trade-off refer to the correlation between the potential hazards and NOTES
benefits associated with investment. There is a positive correlation between higher levels
of risk and higher returns, as seen in Figure 10.1 below. Conversely, lower levels of risk
may be associated with lower returns.
Figure 10.1: Risk/Return Trade-Off

RISK / RETURN TRADEOFF

Lower Risk Higher Risk

Higher Potential Return
Return

Lower Return

Risk

Source: https://www6.royalbank.com

Investing in private firm equity shares entails a greater level of risk, but it also generates
a higher rate of return. Therefore, it is advisable to allocate investments from this specific
pool of funds in order to optimise our profits by balancing the trade-off between the risk
and return associated with different investment opportunities.

CHECK YOUR PROGRESS – I

1. State whether the following statements are True (T) or False (F).
(a) The two basic dimensions of any financial decision are risk and return.
(b) The term risk refers to the probability of getting no return on investments.
(c) Risk and return are negatively related to each other.
(d) Systematic risk is diversifiable.

10.3 RISK-FREE RETURN, MARKET RETURN AND CAPM

10.3.1 RISK-FREE RETURN
A risk-free return is the rate of return on an investment that does not include any possibility
of financial loss. Within financial markets, the notion of a risk-free return is commonly
associated with government assets, specifically Treasury bills or bonds. These securities
are deemed almost risk-free because to their government-backed credit, resulting in a 261
very low probability of default. The risk-free return acts as a benchmark, signifying the
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NOTES lowest return an investor should anticipate when allocating money. Investors frequently
utilise the return on risk-free assets as a benchmark for assessing the success of other
investments, taking into account the concept of the time value of money when making
financial decisions. The risk-free rate is an essential element in financial models like the
Capital Asset Pricing Model (CAPM), aiding in the calculation of the necessary rate of
return for more risky investments.
Indian Treasury securities exemplify a risk-free investment. Some risk-free investing
options in India include bank fixed deposits, RBI Savings bonds, and the Public Provident
Fund (PPF).
The following table displays the interest rates for T-bills in the years 2023 and 2024.
Table 10.1: The Interest Rates for T-Bills (2023 and 2024)

Item/ Week Ended 2023 2024

91-Day Treasury Bill (Primary) Yield 6.94% 7.02%
182-Day Treasury Bill (Primary) Yield 7.30% 7.19%
364-Day Treasury Bill (Primary) Yield 7.39% 7.13%

10.3.2 MARKET RETURN

Market return, however, signifies the comprehensive performance of the financial
markets, usually assessed by a wide-ranging market index like the NIFTY 50 for Indian
equities. It refers to the overall profit earned by a varied collection of financial assets that
mirrors the changes in the market. The market’s performance is determined by a multitude
of factors, such as economic circumstances, business earnings, geopolitical events, and
investor attitude. Contrary to the risk-free return, the market return carries a level of
risk, and the actual returns might vary. Investors frequently evaluate the performance of
their portfolio by comparing its return to the market return, in order to gauge how well
their investments are doing in relation to the overall market. The difference between the
market return and the risk-free return is commonly used to measure the risk premium that
investors require for assuming the extra risk associated with stocks or other investments
in comparison to risk-free assets. Comprehending both the return that carries no risk
and the return from the market is essential for investors in creating portfolios that are
well-balanced and in making educated choices regarding investments.
The average value for India during that period was 19.7 percent with a minimum of −37.02
percent in 2003 and a maximum of 119.03 percent in 1992. The latest value from 2021 is
21.5 percent.
(Source: https://www.theglobaleconomy.com/India/Stock_market_return/)

10.3.3 CAPITAL ASSET PRICING MODEL (CAPM)

Measuring the cost of stock is challenging since corporations are not legally required to
pay dividends, unlike the comparatively straightforward calculation of the cost of debt
and preference.
Several approaches have been suggested for determining the cost of capital, given the
important role that the cost of equity plays. The methodologies encompassed in this list
262 are the dividend discount model, capital asset pricing model (CAPM), Fama-French model,
arbitrage pricing theory, bond yield plus risk premium approach, and earnings/price
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approach. The capital asset pricing model is currently the dominant method used to NOTES
determine the cost of an approach. Therefore, we will provide more space to it. The
subsequent section will discuss the other approaches.
We will not get into the details of theory in this context, as investing and finance courses
extensively discuss the Capital Asset Pricing Model (CAPM). Instead, we will focus on the
implementation of it.
According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any
investment is determined by adding the risk premium, which is calculated by multiplying
the security’s beta by the market risk premium, to the risk-free rate.
E (Ri ) =
R f + b i [E (RM ) − R f ]

where E(Ri) is the expected return on security i, Rf is the risk-free rate, bi is the beta of
security i which reflects its sensitivity to the market, and E(RM) is the expected return on
the market. [ E(RM) – Rf] is referred to as the market risk premium.
According to the Capital Asset Pricing Model (CAPM), the beta of a firm may differ, but the
risk-free rate and market risk premium remain constant for all companies.
Although the CAPM has a solid theoretical basis (its main creator, William Sharpe,
received the Nobel Prize in Economics in 1990), it provides limited guidance for practical
implementation.
In order to utilise the CAPM, we need to get estimates for the following variables:
• Beta;
• Market risk premium;
• Risk-free rate

The market risk premium, sometimes referred to as the risk premium, is a key concept
in finance, particularly in models such as the Capital Asset Pricing Model (CAPM).
The calculation involves subtracting the risk-free return from the market return, which is
represented as (Rm−Rf). This disparity signifies the supplementary yield that investors want
in order to assume the increased risk linked to investing in the overall market. The market
risk premium is a form of compensation that investors receive for the increased level of
return volatility and uncertainty they may face compared to the risk-free rate.
Within the framework of the CAPM formula, the anticipated yield on an investment (Ri) is
calculated by summing the risk-free rate (Rf) with the product of the asset’s beta (a measure
of systematic risk) and the market risk premium (Rm–Rf). This equation encapsulates the
concept that investors want not just remuneration for the opportunity cost of money
(represented by the risk-free rate) but also an additional premium to accommodate the
risk associated with market investments.
The surplus return expected in the market risk premium plays a vital role in investing
decision-making. Investors evaluate the additional cost compared to the danger they
take on when investing money in stocks or other market-related assets. It quantifies the
amount of compensation required to incentivize investors to accept the risks associated
with market volatility. When the market risk premium is positive, it means that investors
expect to receive better returns in exchange for taking on extra risks. Conversely, a negative 263
premium may indicate a preference for the safety of risk-free assets.
UNIT 10
Discounting Rate

NOTES Gaining an understanding of the market risk premium offers investors significant insights
into the relationship between risk and return. It provides guidance for their expectations and
aids in evaluating if the anticipated return of a possible investment appropriately justifies
the associated risks. The market risk premium plays a crucial role in financial research and
decision-making, aiding in the development of educated investment strategies.
Now, let’s comprehend this by using a few hypothetical examples.
Illustration 1: Alpha Holdings Ltd., an investment company has invested in equity shares
of a blue-chip company. Its risk-free return is 10%, its Beta is 1.50, and the expected
market return is 16%. Calculate the expected rate of return on the investment made in
the security.
Solution:
Ke = Rf + [βi × (Rm – Rf)]
Given,
Rf = 10
βi = 1.5
Rm = 16
Ke = 10 + [1.5 × (16 – 10)] = 19%
Thus, the expected rate of return on the investment made in the equity shares is 19%.
Illustration 2: ZED ltd. has a beta coefficient of 1.8. It finds the risk-free rate to be 8%
and the market cost of capital to be 14%. Calculate the expected rate of return on equity
shares.
Solution:
Ke = Rf + [βi × (Rm – Rf)]
Given,
Rf = 8
βi = 1.8
Rm = 14
Ke = 8 + [1.8 × (14−8)]
= 18.8%
Thus, the expected rate of return on the investment made in the equity shares is 18.8%.

CHECK YOUR PROGRESS – II

1. Fill in the blanks:

(a) The required rate of return on security as per CAPM is
(b) The market risk premium is
(c) CAPM was created by
2. Multiple choice questions:
(a) The relationship between systematic risk and return is described by:
(i) CAPM
(ii) Arbitrage Pricing Theory
264 (iii) Capital Market Line
(iv) Harry Marketing Model
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3. State whether the following statements are True (T) or False (F). NOTES
(a) The degree of risk and risk premium are directly related to each other.
(b) CAPM is used to measure the risk-return relationship of any type of asset.

10.4 CONCEPT OF BETA

In this section, we will talk about the concept of beta.
The beta of an investment in the Capital Asset Pricing Model (CAPM) quantifies the level
of risk it introduces to a market portfolio.
The conventional approach to calculate an investment’s beta is by comparing its returns
with the returns of a market index. Calculating the gains obtained by an investor who
purchased the company’s shares at regular intervals, such as weekly or monthly, during
the duration of a well-established public listing, is a very simple task. To determine the
betas of the assets, it is necessary for the stock returns on these assets to be connected
with the returns on a market portfolio, which comprises all traded assets. Typically, we
calculate stock betas by comparing them to an index of equities, such as the S&P 500, and
use this as a substitute for the whole market portfolio.
Below is a comprehensive, sequential tutorial on the process of calculating beta:

10.4.1 COLLECT DATA

• Gather historical price data for the security you’re analysing (e.g., a stock) and the
corresponding market index (e.g., S&P 500).
• Ensure that you have enough data points, typically spanning several months or
years, to capture meaningful trends and fluctuations.

10.4.1.1 CALCULATE RETURNS

• Calculate the periodic returns for both the security and the market index. Returns
are typically calculated as the percentage change in prices from one period to the
next.
• Use the following formula to get the return for each data point:

 Price Current − PricePrevious 

=Return   × 100
 PricePrevious 

• For each data point in your dataset, perform this computation one again.

10.4.1.2 CALCULATE COVARIANCE

• Determine the covariance between the returns of the security and the market
index. Covariance quantifies the degree to which two variables exhibit a similar
pattern of movement.
• Utilise the subsequent formula to compute covariance:

COV (Rs , Rm ) =
( )(
Σ ni=1 Rs ,i − Rs Rm ,i − Rm ) 265
n −1
UNIT 10
Discounting Rate

NOTES Where,
Rs = Returns of the Security
Rm = Returns of the Market Index
Rs = Mean of the Security Returns
Rm = Mean of the Market Returns
n = Number of Data Points

10.4.1.3 CALCULATE VARIANCE

• Calculate the variance of the returns for the market index. Variance measures the
dispersion of returns around the mean.
• Use the formula:

( )
2
Σ ni=1 Rm ,i − Rm
Var (Rm ) =
n −1

10.4.1.4 CALCULATE BETA

• Finally, calculate the beta coefficient using the formula:

Cov ( Rs , Rm )
b=
Var (Rm )

The beta value measures the responsiveness of a security’s returns to fluctuations in the
overall market returns. A beta value more than 1 implies that the asset has a higher level
of volatility than the overall market, whilst a beta value less than 1 says that the security
has lower volatility relative to the market. A beta value of 1 indicates that the security’s
movements are perfectly correlated with the overall market.
Accurate results in calculating beta depend on considering the type of return, frequency
of return, and duration of the past period for both securities and market returns. Here is
a comprehensive analysis of each individual aspect:

10.4.1.5 TYPE OF RETURN

• Beta calculations often employ logarithmic returns or simple returns.
• Logarithmic returns, often referred to as continuously compounded returns,
are favoured due to their ability to offer a more precise depiction of investment
performance over extended periods, particularly for longer durations.
• Simple returns, which measure the percentage change in price, are easier to
compute and are commonly employed for shorter-term analysis.

10.4.1.6 FREQUENCY OF RETURN

• The frequency of returns pertains to the time intervals at which returns are
computed, for as on a daily, weekly, or monthly basis.
• Higher-frequency returns, such as daily or weekly returns, offer more detailed
266
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• Lower-frequency returns, such as returns calculated on a monthly or quarterly NOTES
basis, help to reduce the impact of short-term fluctuations in the market. However,
they may fail to capture significant market moves.

10.4.1.7 LENGTH OF PAST PERIOD

• The duration of the previous period pertains to the time span over which historical
returns are examined.
• The duration of the previous period is contingent upon the investment time frame
and the accessibility of historical data.
• Lengthier durations, encompassing multiple years, offer a more all-encompassing
perspective on the security’s performance in relation to the market. However, they
may not accurately reflect the current state of the market.
• Briefer durations, such as one year or less, capture more recent market trends but
can be affected by temporary fluctuations and irrelevant data.
The selection of the return type, frequency, and duration of the historical period is
determined by the unique attributes of the asset, the market, and the investor’s goals. It is
crucial to achieve a harmonious equilibrium between identifying significant patterns and
reducing extraneous data interference to produce accurate beta values. By conducting
experiments with various combinations of return kinds, frequencies, and historical
periods, one may enhance the accuracy of the beta calculation and get useful insights into
the correlation between the security and the market.

CHECK YOUR PROGRESS – III

1. Fill in the blanks:
(a) Beta for the market portfolio is
(b) Beta is used to assess both and
(c) An inverse correlation between the stock and the market is shown by a beta
of
2. Multiple choice question:
(a) The beta of risk-free investment is:
(i) 1
(ii) −1
(iii) Zero
(iv) None of these
3. State whether the following statements are True (T) or False (F).
(a) β is a measure of the expected return of a security.

10.5 COST OF EQUITY

The metric used by businesses to assess whether an investment meets the requirements
for capital return is referred to as the cost of equity. Businesses may utilise it as the
requisite rate of return benchmark for capital budgeting. A company’s cost of equity is the 267
price that the market demands in exchange for ownership of the asset and assuming the
UNIT 10
Discounting Rate

NOTES related risk. The capital asset pricing model (CAPM) and the dividend capitalization model
are often used methods to calculate the cost of equity.
It is well acknowledged that equity share capital, like to other forms of capital, incurs a
cost. The return on investments in the business differs depending on the kind of capital.
Debt and preference share capital have a fixed coupon rate. However, for equity share
capital, investors need to determine the expected return from the firm, which comes in
the form of dividends and capital gains. To determine the current value of the return, it is
necessary to discount the anticipated stream of dividends. The rate of discount referred
to as the cost of equity or cost of equity share capital.

10.5.1 COST OF EQUITY BY CAPM

The calculation of cost of equity as per CAPM model has been explained in previous
section. Let’s summarise the main points here:
The cost of equity, as defined by the Capital Asset Pricing Model (CAPM), represents the
minimum rate of return required by investors to compensate for the risk associated with
investing in a certain stock. The Capital Asset Pricing Model (CAPM) is a commonly utilised
framework for estimating the anticipated return on equity investments. It is founded on
the principle that investors want compensation for two factors: the systematic risk (beta)
associated with the investment and the time value of money.
The following formula may be used to determine the cost of equity using CAPM:
Cost of Equity (CAPM) = Rf + b × (Rm – Rf)
Where:
• Rf represents the risk-free rate of return, which is usually obtained from Treasury
bills or government bonds. It shows what investors could make in return if there
was no default risk.
• b indicates the stock’s systematic risk, which gauges how vulnerable its returns are
to changes in the market as a whole. When the beta is 1, it means that the stock
moves in lockstep with the market; when the beta is less than 1, it means that the
stock moves less volatilely.
• (Rm – Rf) is the excess return investors anticipate receiving for assuming the greater
risk of investing in the market as opposed to risk-free assets. This is known as the
market risk premium.
The required rate of return for equity investors is calculated using the Capital Asset
Pricing Model (CAPM), which considers the risk-free rate of return, the stock’s beta, and
the market risk premium. It provides investors with a systematic approach to assess the
expected return and inherent risk of a company relative to the market. This enables
them to make educated choices and compare the attractiveness of different equity
investments.

10.5.2 COST OF EQUITY BY DDM

There are types of models in the Dividend Discount Model (DDM) along with situations
where they are typically used:

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Table 10.2: Dividend Discount Model (DDM) along with situations
NOTES
Model Type Description Situation
Used for mature companies
Assumes that dividends remain
No Growth with stable earnings and
constant over time.
dividend pay-outs.
Suitable for companies with a
Assumes dividends grow at a
Constant Growth stable and predictable growth
constant rate indefinitely.
trajectory.
Allows for different growth Applicable for companies
Multi-Stage rates in different stages of the experiencing varying growth
company’s life cycle. phases.
Each model type caters to different eventualities based on the organization’s dividend
policy, growth expectations, and developmental stage. The model employed will depend
on several factors, such as the company’s historical achievements, the condition of the
industry, and anticipated future expansion.
• The No Growth Model is used when it is expected that a company’s dividend
payments would remain constant over time. It is suitable for well-established
enterprises operating in stable industries with limited opportunities for development
and predictable increases in profits.
• The Constant Growth Model assumes that dividends will perpetually rise at a
consistent rate. It is commonly employed by organisations experiencing consistent
and predictable growth rates, often in stable markets with sustained demand.
• The Multi-Stage Model considers the growth of enterprises at varying rates
at different stages of their lifespan. This is commonly employed by firms that
experience phases of fast growth, followed by slower growth or reaching a stable
state. This technique allows for greater flexibility in showing the dynamic potential
for the company’s growth.

The Dividend Discount Model (DDM) Cost of Equity is utilised to compute the requisite
rate of return that investors demand to acquire a certain company, considering the
projected dividends of the organisation. The intrinsic value of a company is calculated
using the Dividend Discount Model (DDM), which involves discounting the future
dividend payments to their present value. The cost of equity refers to the rate of
return that measures the relationship between the stock price and the current value of
predicted future dividends.
The Dividend Discount Model (DDM) may be utilised to compute the cost of equity by
employing the subsequent formula:
D
Cost of Equity (DDM)= 1 +g
P0
Where:
• D1 represents the expected dividend per share to be received in the next period.
• P0 denotes the current price of the stock.
• g represents the expected growth rate of dividends.

269
UNIT 10
Discounting Rate

NOTES The first term

D1
symbolises the dividend yield, which is the ratio of the stock’s current
P0
price to the predicted dividend per share. It represents the expected return on investment
that investors have for dividends alone.
The second term, g, represents the predicted growth rate of dividends. The Gordon
Growth Model, a variant of the DDM, posits a constant growth rate across time. It displays
the anticipated rate at which dividends will increase in the next years.
The cost of equity, as measured by the Dividend Discount Model (DDM), is equal to the
sum of the dividend yield and the expected dividend growth rate. Investors can assess
the appeal of a company by considering its current price and expected dividend growth
using the valuation framework it provides. This framework is based on the present value
of predicted future dividends.
Illustration 3: Axita Cotton Ltd. declared and paid interim dividends at the rate of 10% on
equity shares of Rs. 100 each in November 2023. Calculate the cost of equity share capital
if the present market price of equity shares is Rs. 160.
Solution:
Where,
ke = Cost of Equity Share Capital
D1 = Expected Dividend per share
Po = Current market price per share
Given,
D1 = 10% of Rs. 100 i.e. 10
Po = Rs. 160
ke = 10/160
ke = 0.065 or 6.5%
(https://www.moneycontrol.com/stocks/marketinfo/dividends_declared/index.php)

10.5.3 DIVIDEND GROWTH METHOD

The dividends under this method are anticipated to increase at a constant rate of ‘g’
percent annually. Therefore, the cost of equity share capital can be calculated as under:
Where,
ke = Cost of Equity Share Capital
D1 = D0 (1 + g); where D0 is the current dividend declared and paid.
Po = Current market price per share
g = Growth in dividend (in %)
There are two parts to the formula above. Divided by the current price, the estimated
cash dividend (D1/Po) represents the dividend yield. The capital gains yield, or g, is the
growth rate.
Illustration 4: Venture Ltd. declared and paid dividends at the rate of 10% on equity shares
of Rs. 100 each. The expected future growth rate is 14%. Calculate the cost of equity share
capital if the present market price of equity share is Rs. 165.

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Solution: NOTES
D
Ke = 1 + g
P0
D1 D0 (1 + g)
=
= 10(1 + 0.14)
= 11.4
11.4
Thus,=
ke + 0.14
165
= 0.209 or 20.9%

10.5.4 EARNING YIELD METHOD

An alternative term for this procedure is the price-earnings ratio approach. This method
posits that investors leverage the continuous flow of future share earnings, which are not
obligated to be in the form of dividends or distributed to shareholders.
Earnings Per Share
Ke =
Market Price Per Share

Illustration 5: Pluto Ltd. has 45,000 equity shares of Rs. 10 each and its current market
value is Rs. 45 each. The profit after tax of the company for the year ended 31st March 2023
is Rs. 9,50,000. Calculate the equity cost of capital based on the earning yield method.
PAT
Solution: Earning Per Share (EPS) =
No. of Shares
9,50,000
EPS =
45,000
= Rs. 21.11
Ke = 21.11/45
= 0.469 or 46.9%

10.6 COST OF DEBT

From a conceptual standpoint, the yield to maturity of a debt instrument represents its
cost.
Let’s apply this idea to other financial products, including commercial paper, bank loans,
and debentures.
The cost of a debenture is the value of rD in the following equation.
I F
∑
n
=Po +
t =1 (1 + r )
D (1 + rD )n

where n is the number of years to maturity, F is the debenture’s maturity value, I is the
yearly interest payment, and P0 is the debenture’s current market price.
271
UNIT 10
Discounting Rate

NOTES The internal rate of return, or rD, in the equation above must be calculated by trial and
error. If you prefer not to go through the process of trial and error, you may use the
following formula, which provides an extremely accurate approximation of the proper
value.

I + ( F − P0 ) / n
rD =
0.6P0 + 0.4 F

Take a look at the following Multiplex Limited debenture to see how this calculation works.
Face value: 1,000
Coupon rate: 12 percent
Remaining period to maturity: 4 years
Current market price: 1040
The approximate yield to maturity of this debenture is:

120 + (1000 - 1040) / 4

rD = = 10.7%
0.6 ´ 1040 + 0.4 ´ 1000

When calculating the cost of debt, the component on the balance sheet treated as debt
is primarily the long-term debt or liabilities of a company. Specifically, the following items
are typically included:
• Bonds Payable: This word pertains to the company’s long-term financial
commitments that are in the form of bonds. Bonds payable denote the principal
sum borrowed by the corporation from bondholders, with a designated date of
maturity and a fixed interest rate.
• Long-term loans: It refer to loans obtained by a corporation that have a payback
duration lasting more than one year. Long-term loans encompass several types of
debt, such as bank loans, term loans, mortgages, and other forms of borrowing
that need extended periods for repayment.
• Finance Leases: Finance leases, often referred to as capital leases, are contractual
obligations resulting from lease agreements in which the lessee (business) is
obligated to make set payments over the duration of the lease, resembling debt
repayments.
• Convertible debt: It refers to financial instruments, such as convertible bonds or
convertible preferred stock, that are initially classified as debt but can be converted
into another form of ownership. These securities are a kind of borrowing that may
be transformed into ownership shares at the choice of the holder.
• Other long-term liabilities, including as pension payments, deferred tax liabilities,
and long-term provisions, may be included in the calculation of the cost of debt if
they include future cash outflows and are treated as debt.

When estimating the cost of debt, it is crucial to prioritise long-term debt commitments.
These liabilities refer to the money borrowed by the firm for a duration that usually exceeds
one year. Typically, the cost of debt calculation does not incorporate short-term obligations,
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such as accounts payable, accruals, and short-term borrowings. These liabilities are more NOTES
closely associated with the company’s management of working capital and its short-term
financing requirements.

10.6.1 COST OF IRREDEEMABLE DEBT OR PERPETUAL DEBT

Irredeemable debt refers to debt that does not require repayment during the company’s
existence. Regular payments are required for the interest rates. The coupon rate of interest
on such debt signifies the pre-tax expense of debt.
The formula for calculating it is:

I (1 − t )
Kd =
NP
Where,
Kd = Cost of Debt
I = Annual interest payment
t = Company’s corporate tax rate
NP = Net Proceeds of issue of debentures
Net proceeds are calculated as:
NP = Total amount of debentures issued – Floatation Cost
Illustration 7: Zoom Technologies Ltd. has issued 20,000 irredeemable 12% debentures
of Rs. 150 each. Floatation cost is 5% of the total issued amount. The corporate tax rate is
40%. Calculate the cost of debt.
Solution:
Given,
I = 12% of (20,000 debentures x Rs. 150)
= Rs. 3,60,000
t = 0.40
NP = 30,00,000 – (5% of 30,00,000)
= Rs. 28,50,000
3,60,000 (1 − 0.40)
Kd =
28,50,000
= 0.0757 or 7.57 %

10.6.2 COST OF REDEEMABLE DEBT

Debt that must be paid back to the investor within a set time frame is known as redeemable
debt. You may compute it with the following formula:
 RV − SV 
I + N  ( 1 − t )
Kd =  
 RV + SV 
 2 
 

273
UNIT 10
Discounting Rate

NOTES Where,
Kd = Cost of Debt
I = Annual interest payment
t = Company’s corporate tax rate
N = Number of years to maturity
Rv = Redeemable value of debt at the time of maturity
Sv = Sales value less discount and floatation costs
Illustration 8: Through the issuance of 10,000 16% debentures at a discount of Rs. 10
per debenture with a 10-year maturity, Rising Star Ltd. has raised funds. The flotation
cost for each debenture is Rs. 5. The debentures are redeemable at a 10% premium. The
corporate taxation rate is 40%. Calculate the cost of debentures.
Solution:
Given,
I = 16% of Rs. 150 i.e. 24
t = 0.40
N = 10
Rv = Rs. 150 + (10% premium on Rs. 150) i.e. 165
Sv = (150−5−10) i.e. 135
 RV − SV 
I + N  ( 1 − t )
Kd =  
 RV + SV 
 2 
 

 165 − 135 
24 + 10  (1 − 0.4 )
=
 165 + 135 
 2 

= 0.108 or 10.8%

CHECK YOUR PROGRESS – IV

1. State whether the following statements are True (T) or False (F).
(a) The coupon rate of interest on perpetual debt represents the after-tax cost of
debt.
(b) The cost of debt is the same as the rate of interest.
2. Fill in the blanks:
(a) The formula for calculation of Net Proceeds is

10.7 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

We will now discuss an important concept, that is, WACC or the weighted average cost of
capital.
The average cost of capital refers to the average cost of obtaining funds from each
274
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referred to as the weighted average cost of capital. A corporation obtains funds at different NOTES
rates through various financing techniques, such as debentures, term loans, equity share
capital, and preference share capital. The market value technique is considered more
pragmatic compared to book value weights, since it utilises the market worth of each
outstanding finance source to compute the respective weights. In addition, the use of
historical book value weights is not applicable in estimating the actual cost of capital.
In simpler terms, the Weighted Average Cost of Capital (WACC) is the overall expense
of obtaining funds for long-term investments, calculated by considering the expenses
associated with different kinds of funding and their respective amounts.
The Weighted Average Cost of Capital (WACC) is a useful tool for determining the most
effective capital structure. The optimal capital structure is the point at which the weighted
average cost of capital (WACC) is at its minimum. When assessing a project, the Weighted
Average Cost of Capital (WACC) is the minimum rate of return required for the project to
satisfy the investors’ anticipated return. In this context, the term “required rate of return”
is synonymous with WACC. The required rate of return is utilised as the discount rate to
compute the value of the project. The Weighted Average Cost of Capital (WACC) may be
determined using the following formula:
WACC = (Equity Cost × Equity Weight) + (Debt Cost × Debt Weight)

Illustration 9: 32,000 equity shares, valued at Rs. 100 each, were the subject of a 10%
dividend declaration and payment by Angel Reach Ltd. Future growth is anticipated to
reach 12%. Equity shares currently trade at Rs. 185. 30,000 irredeemable 12% debentures,
at Rs. 160 each, have been issued by it. 5% of the entire amount issued is the flotation
cost. 40% is the corporate tax rate. Compute the WACC.
Solution: Let us first calculate the cost of equity and cost of capital
D1 = D0 (1 + g)
= 10(1 + 0.12)
= 11.2
11.2
Thus, = + 0.12
185
= 0.1805 or 18.05%
I(1−t)
Kd =
NP

Given,
I = 12% of (30,000 debentures × Rs. 160)
= Rs. 5,76,000
t = 0.40
NP = 48,00,000 − (5% of 48,00,000)
= Rs. 45,60,000
5,76,000 ( 1 − 0.40 )
Kd =
45,60,000
= 0.0757 or 7.57 %
WACC = (Cost of Equity × % of Equity) + (Cost of Debt × % of Debt) 275
UNIT 10
Discounting Rate
Table 10.3: Calculation of WACC
NOTES
Source of Capital Amount (Rs.) Weights Cost of Capital WACC (%)
(%)
Equity Shares 32,00,000 0.4 18.05 7.22
Debentures 48,00,000 0.6 7.57 4.54
Total 80,00,000 1.00 11.76
Thus, WACC is 11.76%

CHECK YOUR PROGRESS – V

1. Fill in the blanks:
(a) WACC is also known as
(b) An optimal capital structure is selected based on
2. State whether the following statement is True (T) or False (F):
(a) The historical book value weights are irrelevant when determining the true cost
of capital.
(b) The cost of capital from different sources of finance is the same.
(c) Equity shares have the highest cost of capital.
3. Multiple choice question
(a) WACC computation considers:
(i) Cost of Debt
(ii) Cost of Equity
(iii) Cost of preference shares
(iv) All of the above

10.8 DISTINCTION BETWEEN THE DISCOUNTING RATE FOR

VALUATION OF A PUBLIC COMPANY VIS-À-VIS PRIVATE
EQUITY INVESTMENT
The discounting rate, sometimes referred to as the discount rate or needed rate of return,
is of utmost importance in the process of valuation, whether it is for a publicly traded firm
or a private equity venture. Nevertheless, there are clear disparities in the determination
and use of the discounting rate in these two contexts:

10.8.1 PUBLIC COMPANY VALUATION

• In the valuation of public companies, the discounting rate usually represents the
cost of equity, which is determined using methods like the Capital Asset Pricing
Model (CAPM) or Dividend Discount Model (DDM).
• The cost of equity for a publicly traded firm includes elements such as the risk-free
rate, market risk premium, and beta, which measures the systematic risk of the
company’s shares compared to the overall market.
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• Public business valuations frequently employ the weighted average cost of capital NOTES
(WACC), which is a combination of the cost of stock and the cost of debt, with
each component being weighted according to the firm’s capital structure. The
Weighted Average Cost of Capital (WACC) is the comprehensive rate of return that
encompasses all capital providers, such as equity investors and debt holders.

10.8.2 PRIVATE EQUITY INVESTMENT VALUATION

• Private equity investment valuation sometimes uses a discounting rate that
represents the projected rate of return desired by investors. This rate might be
somewhat different from the cost of equity for publicly traded firms.
• Private equity investments typically entail elevated degrees of risk and uncertainty
in contrast to investments in publicly traded firms. Consequently, private equity
investors usually demand more returns to offset the lack of ability to quickly
convert their investments into cash, the absence of clear information, and the
increased level of risk linked to these investments.
• The discount rate for private equity investments may be estimated by considering
criteria such as the perceived level of risk associated with the investment, the
anticipated return on comparable investments in the market, the duration of the
investment, and the unique attributes of the target firm or project.
Essentially, the discounting rate is a crucial concept in valuing both public companies and
private equity investments. However, the factors that affect its determination and the
actual rate used can differ greatly depending on the type of investment, the level of risk,
and the preferences of investors.

CASE STUDY 1: WACC OF NESTLE INDIA LTD

Nestle India Ltd., a subsidiary of Nestle Switzerland, operates in four main sectors: drinks,
prepared meals and kitchen utensils, chocolate and confectionery, milk products and
nutrition, and food vending services. Dairy products and nutrition encompass foods that
are beneficial for infants as well as for pregnant and lactating women. The Powdered
and Liquid Beverages product business sells tea and instant coffee under the trademarks
Nestea, Nescafe Classic, and Nescafe Gold. Maggi offers a range of prepared meals and
cooking gadgets that have tastes designed to improve cuisine. Nestle Alpino, KitKat, and
Munch Nuts are confectionery goods belonging to the chocolate & confectionery category.
The company’s business operations fall within the Food operating section.
Nestle India’s assets are funded by a combination of loan and equity. The beta coefficient
of Nestle India is 0.63. The equity weight is 0.9988, while the debt weight is 0.0012. The
cost of debt is stated at 54.2899%. The equity’s cost is 10.95%. The tax rate is specified as
26.13%.
Q. You are required to calculate WACC of Nestle India Ltd.
(https://www.gurufocus.com/term/wacc/NSE:NESTLEIND/WACC-/Nestle-India-
Ltd#:~:text=As%20of%20today%20(2023%2D11,It%20is%20earning%20excess%20
returns)

277
UNIT 10
Discounting Rate

NOTES CASE STUDY 2: WACC OF PROCTER & GAMBLE

Procter & Gamble, founded in 1837, has become a prominent global manufacturer of
consumer goods, generating annual revenues above $80 billion. The company’s collection
of leading brands consists of over 20 that generate annual worldwide sales over $1
billion. These include Pampers diapers, Charmin toilet paper, Tide laundry detergent, and
Pantene shampoo. P&G divested its last food brand, Pringles, to Kellogg in 2012. Around
53% of the company’s total sales are generated from sales made in regions outside of its
original territory.
Q. Calculate WACC of Procter & Gamble using data in the link given above.
(https://www.gurufocus.com/term/wacc/PG/WACC-Percentage/PG#:~:text=Procter%20
%26%20Gamble%20Co%20(NYSE%3APG)%20WACC%20%25&text=As%20of%20
today%20(2023%2D12,using%20TTM%20income%20statement%20data).

10.9 LET US SUM UP

• Risk, in essence, refers to the level of uncertainty around the potential negative
repercussions of a decision on items that have significance for individuals, such as their
well-being, contentment, possessions, or the natural surroundings.
• Risk refers to the probability that a security may provide a financial gain. The revenue
generated from investing in a security, which might be in the form of interest, dividends,
or the increase in market value of the security, is known as a security return.
• Assuming efficient functioning of the capital markets, every investment asset should
provide a rate of return that is proportional to the associated risks. Due to the inverse
relationship between risk and return, it is expected that a greater-risk investment
would provide a larger return.
• The Capital Asset Pricing Model (CAPM) demonstrates the correlation between the risk
and return of an asset and provides a structure for determining the necessary rate of
return on an asset.
• The relationship between the level of risk inherent in an asset, known as systematic risk,
and the anticipated return on that asset, particularly in the case of stocks, is explained
by the concept of beta in the Capital Asset Pricing Model (CAPM). By quantifying beta,
one may evaluate both the level of systematic risk and the degree of stock volatility.
• When the beta value of stocks is positive, they tend to move in the same direction as
the market. Conversely, when the beta value is negative, stocks move in the opposite
direction of the market.
• The anticipated yield on assets funded by equity is simply the equity cost.
• Dividend Yield Method, Dividend Growth Method, Earning Yield Method, and CAPM
are used in the calculation of the cost of equity.
• In addition to equity, a company’s capital structure has a debt component, which can
be in the form of bonds, debentures, term loans from financial institutions, and other
similar instruments.
• Irrespective of the company’s financial success, the investors are obligated to pay a
fixed interest rate on the loan.
• The aggregate cost of capital from several financing sources, calculated by taking into
278 account their respective weights, is referred to as the weighted average cost of capital.
 FINE005
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When assessing a project, the Weighted Average Cost of Capital (WACC) is seen as the NOTES
minimum rate of return required for the project to achieve the anticipated return for
investors.
• The evaluation of an investment proposal is conducted using the capital budgeting
approach called internal rate of return (IRR), which is the discount rate expressed as
a percentage. The investment plan is approved if the internal rate of return (IRR) is
higher than the weighted average cost of capital (WACC).

10.10 KEYWORDS
Beta (β): It is the systemic risk associated with a security.
Capital Asset Pricing Model (CAPM): a model that provides a framework for determining
the needed rate of return on an asset and shows how the return and risk of the asset are
related.
Cost of Debt (Kd): a fixed rate of interest payable to the investors irrespective of the
profitability of the firm.
Cost of Equity (Ke): rate of return the company pays out to equity investors.
Cost of Irredeemable Debt: debt which need not be repaid over the lifetime of the company.
Cost of Redeemable Debt: debt that has to be repaid to the investor within a specific period.
Internal Rate of Return (IRR): the percentage discount rate that is applied to project costs
and anticipated cash inflows when evaluating capital investments.
Market Return: the interest rate that lenders and borrowers are willing to pay based on
the transaction’s level of risk.
Return: income earned from investing in a security, which is in the form of interest,
dividend, or market appreciation of the value of the security.
Risk: risk is the probability of getting a return on any security.
Risk-Free Return: return from an investment that carries no risks and guarantees a return.
Weighted Average Cost of Capital (WACC): the total cost of capital, which is obtained by
weighing costs from various long-term fund types, according to their relative proportions.

10.11 REFERENCES AND SUGGESTED ADDITIONAL READINGS

REFERENCES
1. Rustagi, R.P. (2023). Financial Management. Taxmann.
2. Chandra, P. (2022). Financial Management. McGraw Hill.
3. Kishore, R.M. (2020), Financial Management. Taxmann.
4. Pandey I.M. (2021), Financial Management. Pearson.
5. Ender Demir, Ka Wai Terence Fung & Zhou Lu (2016) Capital Asset Pricing Model and
Stochastic
Volatility: A Case Study of India, Emerging Markets Finance and Trade, 52:1, 52-65, DOI:
10.1080/1540496X.2015.1062302 279
UNIT 10
Discounting Rate

NOTES https://www.worldwidejournals.com/indian-journal-of-applied-research-(IJAR)/article/
study-on-determining-whether-stock-is-under-priced-or-over-priced-based-on-capm-
model-a-case-study-of-sensex-companies/NTA4MQ==/?is=1&b1=81&k=21
https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/
article/abs/an-empirical-analysis-of-the-riskreturn-preferences-of-individual-investors/
79BE273BD4C50E39A7EF71CF8CF835F3

SUGGESTED ADDITIONAL READINGS

1. Sharpe, W.F. (2008). Investors and Markets. Princeton University Press.
2. Damodaran, A. (2016). Damodaran on Valuation. Wiley.
3. Hanke, M. (2003). Credit Risk, Capital Structure, and the Pricing of Equity Options.
Springer Vienna.

10.12 SELF-ASSESSMENT QUESTIONS

1. Multiple choice questions
(a) Risk-Return trade-off means:
(i) Maximization of risk
(ii) Ignorance of risk
(iii) Optimization of risk
(iv) Minimization of risk
(b) The beta of an aggressive share is:
(i) Equal to one
(ii) Equal to zero
(iii) Less than Zero
(iv) Greater than one
(c) Debt is a cheaper source of finance due to:
(i) Tax deduction of interest
(ii) Rate of interest
(iii) Time value of money
(iv) Dividend is not payable to lenders
(d) The cost of issuing equity share capital is more than the cost of debt because:
(i) Equity shares can be easily sold.
(ii) The face value of debentures is more than the face value of shares.
(iii) Equity shares have a higher risk than debt.
(iv) All of the above.
(e) The optimal capital structure of an organization is calculated by using:
(i) Cost of Equity
(ii) WACC
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(iii) Cost of Debt NOTES
(iv) All of the above
(f) Tax adjustment is required in the following cost of capital:
(i) Cost of Retained earnings
(ii) Cost of debentures
(iii) Cost of Equity shares
(iv) Cost of Preference shares
(g) While comparing two or more investment proposals:
(i) One with a higher IRR is accepted.
(ii) One with a higher IRR is rejected.
(iii) One with an IRR greater than one is accepted.
(iv) One with an IRR of less than one is accepted.

10.13 CHECK YOUR PROGRESS–POSSIBLE ANSWERS

Check Your Progress – I
(a) T
(b) F
(c) F
(d) F
Check Your Progress – II
1 (a) Sum of risk-free return and product of Beta of security and market risk premium
(b) Rm – Rf
(c) William F. Sharpe and John Linter
2. (a) i
3. (a) T
(b) T
Check Your Progress – III
1. (a) 1
(b) systematic risk and stock volatility
(c) −1.0
2. (a) iii.
3. (a) F
Check Your Progress – IV
(a) ii.
(b) i.
281
UNIT 10
Discounting Rate

NOTES Check Your Progress – V

1. (a) F
(b) F
2. (a) Total amount of debentures issued + Floatation Cost
Check Your Progress – VI
1. (a) Required Rate of Return
(b) WACC
2. (a) T
(b) F
(c) T
3. (a) iv.
Check Your Progress – VII
1. (a) T
(b) F
(c) T
(d) T
2. (a) i.
3. (a) Cut-off rate

10.14 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (d) 3. (a) 4. (c) 5. (b)
6. (b) 7. (d)

282
 UNIT 11
BUSINESS VALUATION – DCF MODEL I

STRUCTURE
11.0 Objectives
11.1 Introduction
11.2 Valuation of Discounted Cash Flow (DCF) Model
11.3 Single-Stage DCF Valuation
11.4 Case Study on DCF Valuation
11.5 Let Us Sum Up
11.6 Keywords
11.7 References and Suggested Additional Readings
11.8 Self-Assessment Questions
11.9 Check Your Progress – Possible Answers
11.10 Answers to Self-Assessment Questions

11.0 OBJECTIVES
After reading this unit, you will be able to:
1. understand the concept of business valuation.
2. interpret the most popular method of business valuation.
3. distinguish between the valuation of the firm and the valuation of the equity.
4. evaluate the value of the firm using the DCF Valuation Model.
5. judge based on the growth rate if a single-stage model of DCF Valuation will
be used.

RECAP OF CHAPTER 10
In the last chapter, the concepts of Beta and market risk were discussed. We also
understood the relationship between the risk and return. The chapter also discussed
how the value of the cost of equity and the cost of debt of a firm can be ascertained.
The concept of weighted average cost of capital discussed elaborately in the previous
chapter will be used in this chapter for the evaluation of the value of the firm. The concept
of cost of equity will be used to evaluate the value of the equity of the firm. The last
chapter used the Internal Rate of Return for the valuation of private equity investment, in
this chapter we will discuss the valuation of the firm and the valuation of equity using the 283
Discounted Cash Flow Method.
UNIT 11
Business Valuation – DCF Model I
NOTES 11.1 INTRODUCTION
In this chapter, we will be using a lot of techniques already taught in the previous chapters
like intrinsic valuation, forecasting of cash flows, time value of money, and weighted
average cost of capital to derive the value of the business.
Firstly, let us understand the term Business Valuation.
Business Valuation is technique of determining the economic worth of a business based
on certain assumptions, future predictions, available data, and estimation of the growth
rate of the company.
Now the important question is: why do we need to value the business? The most important
objective of any business is the wealth maximization of the shareholders. Business valuation
is done to find out the worth of the business, for all the stakeholders who have invested in
the company and other stakeholders who are interested in the financials of the company like
the creditors and potential investors. Business valuation also becomes important during the
case of a Merger or Acquisition, privatization of the company, or joint venture agreement.
The acquiring company wants to know the worth of the business they are acquiring.
Businesses put a lot of time and effort into creating growth plans with specific objectives
to increase the value of their businesses. These strategies are made to maximize value
over time, but without a clear starting point, it can be difficult to meet those objectives.
Shareholders must know how much their company is currently valued, and what factors
contribute to and reinforce that value.
The traditional reason for business valuation is that assessments are required to settle
legal or tax matters. But in reality, valuations are carried out for a variety of purposes,
including but not restricted to buying or selling a business. Valuations are required to
fairly evaluate the conditions specified in court documents. It is also required when the
Business is planning an Employee Stock option plan, splitting of business, gift or donating
company shares as part of a charity contribution, or selling part of the business, for
privatization. Additionally, while trying to secure a Small Business Loan or raise strategic
capital, businesses or even creditors/lenders would often conduct a valuation.
Value judgement is, in fact, both a science and an art form. Estimating the economic value
of an owner’s stake in a business is done through a method and set of procedures known
as business valuation. A closely held company’s precise valuation is a crucial tool for
business owners to evaluate opportunities and opportunity costs while making plans for
expansion and eventual transition. It offers an owner’s relative value at any given moment
or indicates the price a buyer would be prepared to pay to purchase the company.
Business valuation is a highly technical process that involves both theory and practice.
Numerous techniques are used in business evaluation, some of the popular ones are
listed below. The most used business valuation techniques are:
• Market Approach
• Relative Valuation Approach
• Asset Approach
• Return on Investment Approach
However, it should be noted that none of this method is universal and business generally
rely on more than one method since each method has its pros and cons and use different
284
variables for evaluation.
 FINE005
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Let us go through these approaches in detail. NOTES
Market Approach: This method values the business based on the current market price
of its equity shares. Hence the market value of the firm will be the product of the total
number of outstanding shares of the firm and the current market price of the shares,
which is also known as the Market Capitalization of the firm.
For example, the market price of shares of Bajaj Finance Ltd. as on 8th November 2023, was
Rs. 7435 per share and the total outstanding shares of Bajaj Finance Ltd. was 604,361,722,
then the value of the firm is 7435 x 604,361,722 = Rs. 4,49,342 crores. The market value
of the share as per (https://www.moneycontrol.com/india/stockpricequote/finance-nbfc/
bajajfinance/BAF)
Now this becomes technically difficult since the price of shares fluctuates a lot even in a
single day. The mechanism used by the valuer is to take a 2-week average or 6- 6-month
average whichever is higher. The problem with this method is that it does not take into
consideration the assets, the turnover, and the future cash flows of the company. It does
not take into consideration the value of the debt of the firm. Also, for private companies
not listed on the stock exchange, the market price of the share is not available. This method
is solely dependent on the market price of the share which during a merger or acquisition
tends to be highly volatile. The market price of the share is sensitive to the economic and
geo-political, sentiments of investors and not solely on the value of the assets and its
prospect of creating future value for the shareholders. This method is used by the valuer
since the information is readily available but the valuer uses it with caution due to its
various limitations.

Relative Valuation Approach: In this method, the valuation of the business relies heavily
on the valuation of its competitors. The value of the business is assumed to be like the
value of the competitor with a similar structure and net worth. In case, there is no
competitor with a similar structure and value, then the value of market capitalization of
the competitors from the same industry is derived, this value is divided by the income,
or any other benchmarking figure of the respective company to arrive at a comparable
figure for both the companies to find out if the firm is overvalued or undervalued.
Check out how relative valuation is done (https://valueinvesting.io/MSFT/valuation/
pe-multiples#:~:text=As%20of%202023%2D11%2D08,on%20Relative%20Valuation%20
is%200.7%25)
This method is relatively imprecise and frequently relies on negotiable elements. That said,
it may be a useful starting way to determine what a business is worth, but due to its
relative inaccuracy, you may not want to solely depend on this method. In case a similar
comparable business is not available the assets of the company are evaluated based on a
similar asset’s market price to determine the value of the business.

Comparable Transaction Approach

• The comparable transaction approach involves analyzing the prices paid in recent
transactions involving similar businesses. This approach is particularly useful in
mergers and acquisitions.
• In this method, the valuator identifies comparable transactions, which are
acquisitions or sales of businesses that are similar to the subject company in terms
of industry, size, and other relevant factors. 285
UNIT 11
Business Valuation – DCF Model I
NOTES • The valuator then analyzes the transaction multiples (similar to those used in
relative valuation) paid in these comparable transactions to derive valuation
metrics for the subject company.
• For instance, if similar companies in the same industry were recently acquired at
an average EV/EBITDA multiple of 8, the subject company might be valued based
on this multiple.
Asset Approach: This method uses the readily available data from its financial statement
to value to the business. The worth of the business is the difference between the assets
and liabilities of the business. It is based on the accounting concept of C + L = A. The sum
of the total capital and liabilities of a company is equal to the value of its total assets.
Hence the value of the company is C = A - L. This method is also known as the book value
method. The issue with the method is that the book value of the assets does not reflect its
market value since most of the assets carried in the books are at historical cost. Even if a
fair valuation of assets is adopted to evaluate the worth of the business, the value is highly
subjective, especially for intangible assets.
Let us understand this with the help of an example. Given here is the Balance sheet of SBI
Ltd for the year ending on March 2023, and March 2022.
Table 11.1: Balance Sheet of SBI Ltd

Balance Sheet of State Bank of India (in Rs. Cr.) Mar-23 Mar-22
Equity Share Capital 892.46 892.46
Revaluation Reserve 27,756.26 23,377.87
Reserves and Surplus 2,98,959.73 2,55,817.73
Total Reserves and Surplus 3,26,715.99 2,79,195.60
Total Shareholders Funds 3,27,608.45 2,80,088.06
Deposits 44,23,777.78 40,51,534.12
Borrowings 4,93,135.16 4,26,043.38
Other Liabilities and Provisions 2,72,457.15 2,29,931.84
Total Liabilities 51,89,370.09 47,07,509.34
Total Capital and Liabilities 55,16,978.53 49,87,597.41
Assets
Cash and Balances with Reserve Bank of India 2,47,087.58 2,57,859.21
Balances with Bank’s Money at Call and Short Notice 60,812.04 1,36,693.11
Investments 15,70,366.23 14,81,445.47
Advances 31,99,269.30 27,33,966.59
Fixed Assets 42,381.80 37,708.16
Other Assets 3,97,061.58 3,39,924.86
Total Assets 55,16,978.53 49,87,597.41
Source: https://www.moneycontrol.com/financials/statebankindia/balance-sheetVI/SBI

The value of the firm is equal to C = A − L

286 Hence, the book value of the equity for the year ended on March 2023 is the difference
between Assets and Liabilities, Rs. 55,16,978.53 - Rs. 51,89,370.09, which is equal to
 FINE005
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Rs. 3,27,608.45 crores. However, a better approach is to assess the fair value of assets and NOTES
liabilities and on the basis of that calculate worth of equity.
Return on Investment Approach: The ROI-based approach allows investors and businesses
to estimate the value of a firm by examining an organization’s or asset’s performance over a
specific period and making informed predictions about its probable profitability. Investors
may also look at the company’s net income to determine its profitability. Examining the
return on investment (ROI) can show an organization’s financial health. This method can
further be classified as the one that relies on the prediction of future profit and the other
that uses cash flow, to derive the current value of business. The method that relies on
future profit for business valuation is termed the Price Earning Capacity Value (PECV)
while the method that uses future cash flow is termed the Discounted Cash Flow (DCF)
method. However, of these two methods, DCF is more popular since its dependence is on
cash flow which is the real value, and the profit which is just a book value. In this chapter,
we will be focusing on the latter.
All these approaches have their pros and cons and none of the methods is considered
universally acceptable. Most commonly the businesses do valuation relying on more than
one method which seems to give some feasible results.

CHECK YOUR PROGRESS – I

1. The most popular method of business valuation is
(a) Market value approach
(b) Cost Approach
(c) Discounted Cash flow Approach
(d) Relative Valuation
2. Which method relies on the valuation of the competitors for business valuation?
(a) Market Approach
(b) Cost Approach
(c) Relative Approach
(d) Return on Investment Approach
3. The valuation of the business is done for
(a) Mergers and acquisitions
(b) legal settlements
(c) selling part of the business
(d) All of the above
4. The profit of the company and the cash flow of the company is one and the same.
(a) True
(b) False
5. Valuation of business is both an art and a science.
(a) True 287
(b) False
UNIT 11
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NOTES 11.2 DISCOUNTED CASH FLOW (DCF) VALUATION MODEL
We will now start with developing an understanding about the valuation with DCF Model.
The Discounted cash flow method as the name itself suggests is a method to arrive at the
value of the business by discounting the future cash flow of the business. This is the most
popular method due to its conceptual superiority and more accurate valuation of the business
as compared to other methods listed above. This method discounts the cash flow at the
weighted average cost of capital; so, it is not affected by any other externalities. Hence this
method is also known as the intrinsic valuation of business. The following are the requirements
to derive the value of the business through the discounted cash flow method:
• The objective of the valuation
• The Cost of the capital
• The future estimation of cash flow
• The expected period of cash flow
• Forecasting the growth in cash flow in the future period
These steps are discussed in detail as follows:
The objective of the valuation: It is important to know what is the purpose of the valuation.
If the valuation is to ascertain the value of the whole business/firm or to ascertain the
value of the equity. Since both require different calculation techniques. For the valuation
of the firm, we use FCFF and for the valuation of the equity we use FCFE, which is discussed
in detail in the next section. DCF Evaluation in general means evaluation of FCFF.
The Cost of Capital: This method is based on the calculation of the present value of the
projected future cash flow. The question that arises now is what should be the discounting
rate for such future cash flow. The discounting rate will vary depending on the objective of
valuation. If the valuation is to be done for the whole firm, the discounting rate will be the
Weighted Average Cost of Capital (WACC), while for the valuation of the equity, the cost
of equity is used as the discounting rate.
The future estimation of cash flow: The prediction of cash flows that will be generated in
the future is determined based on the current performance of the business, the growth
rate, the stage of business in its life cycle, and the future projects and development
that the business in planning to undertake. It is also important to ascertain the future
capital expenditure and working capital investment to derive the value of free cash flow.
This should be clear by now since you have already studied techniques of the forecasting
of cash flow in the previous chapter.
The expected period of cash flow: How long is the life of a business? Does it cease to exist
when its owner dies? We all know that business is a separate legal entity with a perpetual
life. Then how would you know the value of all the cash flow of the business coming from the
infinite life of the business? This problem is very well addressed in the Discounted Cash flow
valuation, where the future period is divided into two parts: the absolute forecast period
which can range from 3.5 to 10 years, and the continuing value period, wherein we determine
the value of the business in its remaining perpetual life. How well can we forecast the cash
flow is dependent on what stage the business is, in, what kind of industry the business falls to,
and what is the growth rate of the company. This period generally ranges from 3 to 10 years
288 and is known as the Absolute Forecast Period (AFP), While the remaining period is termed as
the remaining perpetual life. The business valuation is done as follows:
 FINE005
Financial Analysis and
Business Valuation
Business Valuation = Present value of the free cash flow for the absolute forecast period NOTES
+ Present value of cash flow in the remaining perpetual life
= PV(FCFF) AFP + PVFCFP

Forecasting the growth rate: The capacity to generate cash flow in a business is highly
dependent on the growth rate of the business. If the growth rate is stable, you will use the
simple Discounted Cash flow valuation. But not all firms have a constant rate of growth, so
what will we do if the growth rate of the company is not stable, especially for a company
that is newly formed? In such cases, we use the Two-stage model, three-stage model, or
multistage model depending on the stages of growth in the business. The DCF Valuation
of a business is divided into two, three, or more stages based on the different growth rates
at each stage. For eg, a start-up has a high growth rate of 20% for the first 5 years, then it
reaches a transition stage wherein the growth rate reduces to 15% for the next 3 years, and
further, it reaches a stable growth rate of 10% forever, so, in this case, we will use the three-
stage DCF Valuation Model.
Let us look for the type of cash flows to be used for firm (FCFF) and equity valuation (FCFE).
Type of cash flows to be used for firm (FCFF) and equity valuation (FCFE)

11.2.1 FREE CASH FLOW TO THE FIRM (FCFF)

FCFF denotes the residual cash flow that remains for investors once a firm has settled all its
operational expenses, allocated funds towards current assets (such as inventories), and made
investments in long-term assets (such as equipment). FCFF include both bondholders and
shareholders as recipients when determining the residual funds available for investors.
The FCFF computation serves as a metric for assessing a company’s operational efficiency
and overall success. FCFF encompasses all cash inflows derived from revenues, all cash
outflows incurred as usual costs, and all reinvested funds utilised for company expansion.
The residual funds remaining after completing all of these processes correspond to a
company’s Free Cash Flow to Firm (FCFF).
Free cash flow is often considered to be the most crucial financial metric in determining
the value of a company’s shares. The valuation of a stock is determined by aggregating
the anticipated future cash flows of the firm. Nevertheless, stock prices are not always
precisely valued. Comprehending a company’s Free Cash Flow to Firm (FCFF) enables
investors to evaluate if a stock is priced appropriately. FCFF is a metric that indicates a
company’s capacity to distribute dividends, repurchase shares, or repay debt holders.
Potential investors interested in investing in a company’s corporate bond or public stock
should assess its Free Cash Flow to Firm (FCFF).

11.2.2 FREE CASH FLOW TO EQUITY (FCFE)

Free cash flow to equity comprises net income, capital expenditures, working capital, and
debt. The company’s net income is reported on the income statement. Capital expenditures
are typically included in the investment portion of the cash flow statement.
Working capital is also shown in the cash flow statement, namely in the cash flows from
the operations activities. Working capital is typically defined as the disparity between a
company’s current assets and liabilities.
These are immediate operational capital requirements with a short-term focus. Net borrowings 289
can be identified in the cash flow statement under the cash flows from financing activities. It is
UNIT 11
Business Valuation – DCF Model I
NOTES crucial to note that interest expenditure is already accounted for in net income, hence there is
no need to include interest expense as an additional amount.
Let us summarize the concept of DCF Calculation for a better understanding.
Table 11.2: DCF Calculations

DCF Valuation can be Valuation Metrics

classified as per
Purpose - DCF Valuation Firm Valuation Equity Valuation
can be classified based on Free cash flow to the Firm Free Cash flow to Equity
purpose, as to whether (FCFF) (FCFE)
you need to determine the
FCFF = EBIT(1 - t) + D - ∆LI FCFE = EBIT(1 - t) - Int (1 - t)
value of the whole firm or
- ∆WC + D - ∆LI - ∆WC
the value of the equity of
+ Net Borrowing
the firm. Hence the two
methods are:
Cost of Capital - The For the valuation of the firm For the valuation of equity
discounting of free available use the Weighted average use the Cost of Equity (Ke)
cash flow is done using the Cost of Capital (WACC) ∞  
Weighted Average cost of  FCFE 
capital or Cost of Equity
∞ 
 FCFF 
 ∑ 
( )

t

based on the purpose of
∑  t


t =1 
 1 + Ke
t =1   (1 + wacc ) 
calculation.
Future Period - The future Absolute Forecast Period For FCFE
period of the firm can be For FCFF ∞  
 FCFE 
divided into the period for
∞   ∑  t

which forecasted values can  FCFF  t =1   (1 + Ke) 
be estimated known as the ∑  t

t =1   (1 + wacc ) 
absolute forecast period.
The remaining perpetual Remaining Perpetual Life For FCFE
life of the firm. The firm’s For FCFF FCFFt (1 + g) 1
value is the sum of the value ×
derived in the Absolute FCFFt (1 + g) 1 Ke - g (1 + Ke)t
×
forecast period and the wacc - g (1 + wacc)t
remaining perpetual life.
Growth Rate - The firms Single-stage Two-stage Three-stage Multi-stage
having a stable growth rate DCF – For DCF – For DCF – For DCF –
will go for single-stage DCF firms having firms expecting firms expecting Generally
valuation, while the firms a stable a higher a higher used for
expecting a higher growth growth rate growth rate growth rate start-ups
rate for some time and now and for some expecting
stable for the rest will adopt then a stable time, terminal varying
two-stage DCF valuation and growth rate growth rate growth
so on, it can be classified as for some time, rates
and then in their
expecting a lifetime
stable growth
290 rate
 FINE005
Financial Analysis and
Business Valuation
CHECK YOUR POROGRESS – II NOTES
1. The DCF Model is considered superior to other methods because
(a) It considers the time value of money
(b) It is not dependent on competitor’s information
(c) It is evaluated based on the forecasted cash flow of the firm
(d) All of the above
2. Which of the following is not required for evaluation of the value of the firm using
the DCF Model
(a) Forecasted cash flow of the firm
(b) The growth rate of the firm
(c) Market value of the share of the firm
(d) The weighted average cost of capital of the firm
3. For the calculation of the value of the firm, we will evaluate the FCFE
(a) True
(b) False
4. The DCF Valuation assumes that the growth rate of the firm remains constant
throughout the life of the business.
(a) True
(b) False
5. The period for which the free cash flow of the firm can be estimated based on
historical data is known as the ____________
(a) The perpetual life
(b) The Absolute forecast period
(c) Free cash flow period
(d) None of the above

11.3 SINGLE-STAGE DCF VALUATION

Discounted cash flow valuation technique based on the objective of valuation
• FCFF (Free cash flow to the firm)
• FCFE (Free cash flow to Equity)
FCFF (Free cash flow to the firm): This method is used when the valuation of the whole
business is to be done, which has been financed by both equity and debt. This is the usual
go-to method adopted for valuation for firms which does not have any information about
their financial leverage and the discounting rate used in this method is the weighted
average cost of capital. Free cash flow to the firm includes the cash flow available to all
the stakeholders namely: equity, preference share, and debt holders of the firm.
Free cash flow to the firm is the cash flow that is left in the business after deducting all 291
the expenses of the year. This is the cash flow that is available to all the stakeholders
UNIT 11
Business Valuation – DCF Model I
NOTES of the firm at the end of the year. The calculation starts with ascertaining the Earnings
before Interest and Taxes (EBIT) as given in the Income statement of any Company.
From this EBIT, the amount of corporate taxes is deducted which generally is given as
a percentage of EBIT. Any Depreciation/Amortization amount deducted from the EBIT
is added back since it does not actually lead to a cash-out flow. The change in the Net
capital expenditure in a specific year is deducted. The net capital expenditure is the
difference between all the Capital expenditure and Capital Gain in a particular year. If it
is a positive figure, it means the capital expenditure of the firm is greater than its capital
gains and vice versa. Similarly, the changes in Net working capital are deducted which
is the difference between the Current Assets and Current Liabilities in a particular year.
The formula to calculate FCFF is as follows:
FCFF = EBIT(1 - t) + D - ∆LI - ∆WC
Where, EBIT = Earnings before interest and taxes
t = tax rate
D = Depreciation and any other non-cash item
∆LI = Changes in Long term Investment
∆WC = Changes in Net Working Capital
Once the FCFF is estimated for the future it is discounted at the weighted average cost of
capital to deduce its present value to the firm:
• Ê FCFF ˆ
Present Value for the Absolute forecast period = Â
t =1 Á
Ë (1 + wacc)t ˜¯
Where FCFF = Free cash flow available to the firm
WACC = Weighted Average cost of capital
t = Time period of discounting
when we mathematically solve this infinite geometric progression then it is converted to
following valuation equation for firms with constant expected rate of growth:
 FCFF1 
Vf =  
 WACC – g 
Similarly, Equity valuation with a firm with expected constant growth rate shall be:
 FCFE1 
Ve =  
 Ke – g 
Let us understand this with the help of a hypothetical example.
Example
Free Cash Flow to the Firm (FCFF) Valuation:
1. Inputs:
• Free Cash Flow (FCF) in the last forecasted year (Year 1): I200 million
• Cost of Capital (WACC): 12%
• Constant growth rate (g): 6%

292
2. Calculation: FCFF = FCFF × (1 + g)​/WACC − g
= I200 × (1 + 0.06)/0.12 − 0.06
 FINE005
Financial Analysis and
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FCFF = I200 × (1.06)/0.06 NOTES
FCFF = I212/0.06
FCFF = I3,533.33 million
So, the estimated FCFF at perpetuity is I3,533.33 million.
Free Cash Flow to Equity (FCFE) Valuation:
1. Inputs:
• Net Income (NI) in the last forecasted year (Year 1): I150 million
• Net Borrowing (NB) in the last forecasted year (Year 1): I50 million
• Dividends (Div) in the last forecasted year (Year 1): I80 million
• Constant growth rate (g): 6%
• Ke = 15%
2. Calculation: FCFE = (NI − Div) + NB × (1 + g)
FCFE = (I150 − I80) + I50 × (1 + 0.06)
FCFE = I70 + I50 × 1.06
FCFE = I70 + I53
FCFE = I123 million
So, the estimated FCFE at perpetuity is I123 million.
 FCFE1 
Ve =  
 Ke – g 
= 123/(15% - 6%) = 1366.67 million
Let us take another example on forecasting of cash flows for absolute forecast period for
which growth can be reasonably estimated and then arrive at firm’s valuation.
Example 1:
Pioneer Corporation Ltd. has given out its financial statement for the current year
2022–2023 and future estimated financial statement for the next five years. The weighted
average cost of capital of the firm is 15%. You are required to calculate the Free Cash flow
to the firm for the absolute future period of 5 years using discounted cash flow from the
given information.

Particulars 2022–2023 2023–2024 2024–2025 2025–2026 2026–2027 2027–2028

Revenue 1250 1305 1320 1325 1335 1340
Less: Operating 770 785 800 805 855 840
Expenses
EBITDA 480 520 520 520 480 500
Less: Depreciation 40 40 40 40 40 40
EBIT 440 480 480 480 440 460
Interest 12 12 11 11 10 10
293
Tax Rate 25% 25% 25% 25% 25% 25%
UNIT 11
Business Valuation – DCF Model I
NOTES The balance sheet of Pioneer Ltd
Table 11.3: Tables Showing the Calculation of Free Cash Flow of Pioneer Ltd

Assets 2022–2023 2023–2024 2024–2025 2025–2026 2026–2027 2027–2028

Fixed Assets 400 400 400 400 400 400
Long-term 250 275 290 280 300 305
Investments
Working Capital 80 85 80 90 90 95
730 760 770 770 790 800
Liabilities 2022–2023 2023–2024 2024–2025 2025–2026 2026–2027 2027–2028
Share Capital 240 240 240 240 240 240
Reserves and 370 405 420 425 450 465
Surplus
Borrowings 120 115 110 105 100 95
730 760 770 770 790 800

Calculation of Free cash flow to the firm

FCFF = EBIT(1 - t) + D - ∆LI - ∆WC
Table 11.4: Calculation of Free Cash Flow

Sr. No. Particulars (Amount in Rs.) 1 2 3 4 5

EBIT 1380.00 1587.00 1825.05 2098.81 2413.63
A EBIT (1 - t) 966.00 1110.90 1277.54 1469.17 1689.54
B Add: Depreciation 126.50 145.48 167.30 192.39 221.25
C Less: Changes in Long-term 30.00 34.50 39.70 45.60 52.48
Investment
D Less: Changes in Working 36.00 41.40 47.61 54.75 62.96
Capital
D Free Cash flow to the firm 1026.50 1180.48 1357.52 1561.20 1795.35
(FCFF) (A+
+B- -C-
-D)

Once the value of FCFF is ascertained we need to discount these values using the WACC
which is 15%, to determine the Present value of these future cash flows.
Hence the

∞  FCFF 
PV(FCFF)AFP = ∑ t =1  t 
 (1 + wacc) 
370 390 420 350 375
= 1
+ 2
+ + +
(1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15) (1 + 0.15)5
3 4

= 321.74 + 294.9 + 276.16 + 200.11 + 186.44

= Rs. 1279.35
294
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The value of the firm is the sum of the present value of the future cash flow of the absolute NOTES
future period and the present value of the cash flow of the remaining perpetual life. Let us
understand the calculation of the cash flow of the remaining perpetual life.

Business Valuation by DCF = Present value of the free cash flow for the absolute forecast period
+ Present value of cash flow in the remaining perpetual life
Due to the assumption of the perpetual life of the business, it does become crucial to
understand the valuation of the cash flow for the whole life of the business. We use the
concept of perpetuity. The calculation is based on the assumption that the free cash
flow of the business will grow at a constant rate of growth(g) forever after the absolute
forecast period. The present value of the free cash flow for perpetual life can be calculated
as follows:
FCFt (1 + g)
FCFP =
wacc – g
Where PVFCFP = Free cash flow for perpetuity
FCFt = Free cash flow after the first year of absolute forecast period which is
equal to the cash flow in
g = constant growth rate of the perpetual free cash flow
Let us assume that Pioneer Ltd, is estimating the Free cash flow to the firm to grow at a
constant rate of 7% p.a. for the rest of its life after the absolute forecast period of 5 years,
i.e. from 6th year till infinity will be

FCFt (1 + g)
FCFp =
wacc – g
375(1 + 0.07)
=
0.15 – 0.07
401.25
=
0.08
= Rs. 5015.625
Once we find out the free cash flow available to the firm for perpetuity, we will find its
present value by discounting it wacc.

FCFFP
PVFCFp =
(1 + wacc)t
5015.625
=
(1 + 0.15)6
= Rs. 2168.3931
Hence, the formula of the Present value of the future cash flow of perpetuity can be
combined and written as follows:
FCFFt (1 + g) 1
PVFCFp
= ×
wacc – g (1 + wacc)t
295
UNIT 11
Business Valuation – DCF Model I
NOTES Hence Value of the firm = PV(FCFF) AFP + PVFCFP

= 1279.35 + 2168.39
= Rs. 3447.74
FCFE (Free cash flow to Equity): This method is applicable generally during acquisition when
the valuation of only the equity of the business needs to be ascertained. This method gives
out the value of the business’s outstanding equity shares and not the business as a whole.
In this method, the cash flow is discounted using the cost of equity and not the weighted
average cost of capital. Even the dividend discount model is used as a substitute for this
method, which is based on the assumption that the free cash flow to equity is the same as
the dividend paid to the equity shareholders.
The free cash flow to the equity is the cash flow available in a year from the profit after
payment of interest on borrowed funds, changes in net capital expenditure, corporate
taxes, changes in net working capital as well as the payment to all the other stakeholders
like debt holders, preference shareholders. This FCFE once calculated is discounted at the
cost of Equity (Ke) to derive at the present value. The formula to calculate the Free Cash
flow available to the Equity shareholder (FCFE) is as follows:

FCFE = EBIT(1 - t) - Int (1 - t) + D - ΔLI - ΔWC + Net Borrowing

Which can also be written as
Table 11.5: Calculation of Free Cash Flow to the Equity (FCFE)

Sr.
No. Particulars 1 2 3 4 5
EBIT 1380.00 1587.00 1825.05 2098.81 2413.63
A EBIT (1 - t) 966.00 1110.90 1277.54 1469.17 1689.54
Interest 12.00 11.00 11.00 10.00 10.00
B Interest (1 - t) 9.00 8.25 8.25 7.50 7.50
C Add: Depreciation 126.50 145.48 167.30 192.39 221.25
D Less: Changes in Long-term 30.00 34.50 39.70 45.60 52.48
Investment
E Less: Changes in Working 36.00 41.40 47.61 54.75 62.96
Capital
F Add: Changes in Net (5.00) (5.00) (5.00) (5.00) (5.00)
Borrowing
Free Cash flow to the Equity 1012.50 1167.23 1344.27 1548.70 1782.85
(FCFE) (A - B - C - D - E + F)

FCFE = FCFF – Int (1 - t) + Net Borrowing

Where Int = Interest payable on long-term Debt
Net Borrowing = New Debt issued – Debt repayment
The Present Value of FCFE is calculated as given, it will be discounted at the Cost of Equity (Ke)

∞  FCFE 
Equity Value = ∑ t =1  (1 + Ke)t 
296  
 FINE005
Financial Analysis and
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Let us Evaluate the Equity value of the firm for Pioneer Ltd with details given as an NOTES
Example 1, Assuming the cost of equity to be 18% p.a.

FCFE = EBIT(1 - t) - Int (1 - t) + D - ΔLI - ΔWC + Net Borrowing

Let Us Evaluate the present value of the FCFE

∞  FCFE 
Equity ValueAFP = ∑ t =1  t 
 (1 + Ke) 
1012.5 1167.23 1344.27 1548.70 1782.85
= 1
+ 2
+ 3
+ 4
+
(1 + 0.18) (1 + 0.18) (1 + 0.18) (1 + 0.18) (1 + 0.18)5
= 858.05 + 838.29 + 818.16 + 798.80 + 779.30
= Rs. 4092.60

Similarly, the Present value of Free cash flow to equity for perpetuity at a constant growth
rate of 7% will be calculated as
FCFEt (1 + g) 1
PVFCFP =
×
Ke – g (1 + Ke)t
1782.85 (1 + 0.07) 1
= ×
0.18 – 0.07 (1 + 0.18)5
= 17342.27 × 0.437
= Rs. 7580.47

Equity value of the firm as per DCF = Equity ValueAFP + PVFCFP = 4092.6 + 7580.47 = 11673.07

11.3.1 DCF VALUATION IN THE REAL WORLD

The discounted cash flow method is widely used to find out the intrinsic value of the
shares. The value of the firm or the value of the equity is derived using the DCF Model and
then divided by the number of outstanding shares to find out the intrinsic value of each
share. If the intrinsic value of the share is greater than the current market price of the
share in the stock exchange, then the shares are considered undervalued and vice versa.
Let us understand how DCF Valuation is used, with the help of a real-world example.

11.4 CASE STUDY ON DCF VALUATION

CASE STUDY OF VISA INC.
The following are the details of Visa Inc. The current value of the FCFE is $20,097 million
which is estimated to grow at the rate of 25.84%, 21.36%, 16.88%, 12.4%, and 7.92% in
the next consecutive five years respectively. After which the firm expects a stable growth
rate of 7.92% for its remaining perpetual life. If the Cost of Equity of the firm is estimated
to be 12.55%, then find the value of the Equity for Visa Inc.
The case has been adapted from (https://www.stock-analysis-on.net/NYSE/Company/
Visa-Inc/DCF/Present-Value-of-FCFE) where you can see how DCF valuation is used to
determine if the shares of Visa Inc. are undervalued or overvalued. 297
UNIT 11
Business Valuation – DCF Model I
NOTES CHECK YOUR PROGRESS – III
1. The Discounted cash flow technique is based on the forecasted value of
(a) Earnings Before interest and taxes
(b) Free cash flow
(c) Net Profit
(d) Assets
2. The DCF Valuation assumes that the growth rate of the company is constant and
does not change at all.
(a) True
(b) False
3. The free cash flow to the equity of the firm is the value of cash flow after all the
deductions available to the all the stake holders except the
(a) Creditors
(b) Preference shareholders
(c) Equity shareholders
(d) Debenture holders
4. For the evaluation of the Free cash flow to the firm the discounting rate used is the
cost of equity
(a) True
(b) False
5. DCF Valuation is predominantly used to evaluate the intrinsic value of the shares.
(a) True
(b) False

11.5 LET US SUM UP

• Valuation of business is difficult and needs a lot of expertise.
• For business valuation, there is market approach, cost approach, and relative approach,
however, the return-on-investment approach is considered the most reliable one.
• When we consider profit and cash flow for the return-on-investment valuation, cash
flow seems to give more accurate results, since profit is based on book value and does
not always reflect money generated. Hence, we can conclude that DCF is the most
popular method of business valuation.
• The discounted cash flow (DCF) technique can be used to find out the value of both the
cash flow available to the firm as well as the cash flow available to the equity holders.
• DCF is highly flexible and can integrate different growth rates.
• DCF is also known as the intrinsic valuation method because, unlike other approaches
298 which consider external factors like the market price of share or the value of business of
the competitor, this method completely relies on internal information of the company
 FINE005
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like the future projection of cash flow, the growth rate of the firm, the Weighted NOTES
Average cost of capital of the firm.
• To accommodate the different levels of growth the DCF Valuation can be classified as the
Single-stage DCF, Two-stage DCF, and Multi-stage DCF Valuation Model. Each of these
models comprises the Absolute forecast period and the remaining perpetual life.
• The absolute forecast period is the period for which the projection of financial
statements can be done, ranging from 3,5 to 10 years. Since the business is assumed
to go on forever the remaining life of the business is considered to be infinity.

11.6 KEYWORDS
Absolute forecast period: The period in the future for which the detailed projection of
cash flow can be done, the period for which the projected financial statements can be
prepared. It generally is 3-10 years depending on the business
Net Borrowings: It is the difference between any new debt instrument issued and the
repayment of debt
Discounted Cash flow: It is the present value of the cash flow of a specific future period.
Discounting: It is the method of finding the present value of a value in the future, based
on the concept of the time value of money.
FCFE: Free cash flow of a firm that is specifically available to the equity shareholders.
It can be found by deducing the cash flow entitled to all the other stakeholders of the
company like the creditors, debt holders, and preference shareholders.
FCFF: Free cash flow to the firm is the amount of free cash flow available after the deduction
of all the cash-out flow and including any inflow to arrive at the value of cash flow that
is available for distribution to all the stakeholders of the company i.e., the debenture
holders, preference shareholders, and equity shareholders.
Forecast period: In this chapter’s context, the forecast period is the period for which the
cash flow of any business is forecasted.
Growth rate: The rate at which the company’s revenue is expected to grow in the future.
Intrinsic value: The intrinsic value is the worth of an asset. The value of the asset is
determined based on its capacity to generate future cash flow.
Long-term Investment: It includes all the capital expenditure in a business in a financial
year. It measures the difference between all capital cash inflows and capital cash flows in
a business.
Time value of money: The time value of money states that the value of a rupee today is
worth more than the value of a rupee in the future. This is the reason that all future cash
flows are discounted to find out the worth of that cash flow today.
WACC: Weighted Average cost of capital is the cost of overall capital of the firm including
all the stakeholders of the firm, namely equity, preference share, and debenture/debt.
WACC = (Cost of Equity x % of equity in the capital structure) + (cost of debt x % of debt
in the capital structure)
Working Capital: The net working capital is the difference between the current assets of
a business and the current liabilities of the business. It shows if there is any cash inflow or 299
outflow while evaluating the FCFF and FCFE.
UNIT 11
Business Valuation – DCF Model I
NOTES 11.7 REFERENCES AND SUGGESTED ADDITIONAL READINGS
REFERENCES
1. Damodaran A. (2012). Investment Valuation. John Wiley & Sons
2. Chandra P. Financial Management. 10th Edition. McGraw Hill
3. Kruschwitz L, Loffler A. Discounted Cash flow: A theory of Valuation of the firm.
Wiley Finance
4. Christy G, C. Free Cash flow. Wiley Finance Series

SUGGESTED ADDITIONAL READINGS

1. Damodaran A. (2011) The Little Book of Valuation: How to Value a Company, Pick a
Stock and Profit. Wiley
2. Shapiro E., Mackmin D, Sams D., (2019) Modern Method of Valuation. 12th Edition.
Estates Gazette.
3. Titman S., Valuation: The art and science of corporate investment Decision.
(2022) 3rd Edition. Pearson Education

11.8 SELF-ASSESSMENT QUESTIONS

1. The value of the firm, C = A - L is as per the _________________ method
(a) Relative Valuation Method
(b) Market Approach
(c) Asset Approach
(d) Return on Investment Approach
2. The valuation of a private company not listed in the stock exchange is not possible
as per the _________________ method
(a) Relative Valuation Method
(b) Market Approach
(c) Asset Approach
(d) Return on Investment Approach
3. The evaluation of DCF for a business with more than 3 growth rate stages is
(a) not possible
(b) evaluated through a two-stage model of DCF
(c) evaluated through sensitivity analysis
(d) evaluated through a multi-stage model of DCF
4. The DCF Valuation cannot be done for
(a) Private Ltd Company
(b) Start-up company with varying growth rate
300 (c) Company whose competitor’s valuation is not available
(d) None of the above
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5. The difference between Free cash flow to the firm and free cash flow to the equity is NOTES
(a) Depreciation and interest
(b) Interest and Changes in net borrowings
(c) Depreciation and changes in net borrowings
(d) Interest and Changes in long-term assets
6. Which rate is used to discount the cash flow in the DCF Valuation to ascertain the
free cash flow to equity?
(a) Cost of Equity
(b) Weighted Average cost of capital
(c) Cost of Debt
(d) Bank rate
7. What concept is used to value the cash flow for the entire life of a business in
perpetuity?
(a) Time value of money
(b) Net present value
(c) Perpetuity
(d) Discounted cash flow
8. Which valuation approach is considered the most reliable for business valuation?
(a) Market approach
(b) Cost approach
(c) Relative approach
(d) Return-on-investment approach
9. Why is cash flow preferred over profit in return-on-investment valuation?
(a) Profit is based on book value
(b) Profit does not always reflect money generated
(c) Cash flow is easier to calculate
(d) Cash flow is based on market value
10. Depreciation is added back while evaluation of the Free cash flow because
(a) Depreciation is a non-cash item
(b) It does not result in cash outflow
(c) Depreciation is not an expenditure but just an accounting entry
(d) All of the above

301
UNIT 11
Business Valuation – DCF Model I
NOTES 11.9 CHECK YOUR PROGRESS – POSSIBLE ANSWERS
Check Your Progress – I
1. (c)
2. (c)
3. (d)
4. (b)
5. (a)

Check Your Progress – II

1. (d)
2. (c)
3. (b)
4. (b)
5. (b)

Check Your Progress – III

1. (b)
2. (b)
3. (c)
4. (b)
5. (a)

11.10 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (b) 3. (d) 4. (d) 5. (b)
6. (a) 7. (c) 8. (a) 9. (b) 10. (d)

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 UNIT 12
BUSINESS VALUATION – DCF MODEL II

STRUCTURE
12.0 Objectives
12.1 Introduction
12.2 Two-Stage DCF Valuation
12.3 Multi-Stage DCF Valuation
12.4 Case Study on DCF Valuation
12.5 Let Us Sum Up
12.6 Keywords
12.7 References and Suggested Additional Reading
12.8 Self-Assessment Questions
12.9 Check Your Progress – Possible Answers
12.10 Answers to Self-Assessment Questions

12.0 OBJECTIVES
After reading this unit, you will be able to:
1. judge based on the growth rate if, two-stage or multi-stage model of DCF
Valuation will be used.
2. develop best-case and worst-case scenarios for valuation to identify key drivers.

RECAP OF UNIT 11
In the last chapter, we discussed the concepts of constant growth as well as the concept of
business valuation. Additionally, we even discussed how the business valuation is a highly
technical process that involves both theory and practice. We also learnt numerous techniques
that are used in business evaluation. The chapter also discussed different approaches like
market approach, relative valuation approach, asset approach and return on investment
approach.

12.1 INTRODUCTION
The Two-Stage Discounted Cash Flow (DCF) Model and Multi-Stage DCF Model are
sophisticated valuation techniques used to assess the intrinsic value of a company’s stock
or business. These models are particularly useful when a company’s growth trajectory is
expected to change over time, making it inappropriate to assume a constant growth rate 303
indefinitely.
UNIT 12
Business Valuation – DCF Model II
NOTES The Two-Stage DCF Model involves breaking down the forecast period into two distinct
stages: an initial high-growth stage followed by a stable growth stage. During the high-
growth stage, the company is expected to experience rapid expansion, often driven
by new product launches, market penetration, or other strategic initiatives. As result,
revenue and earnings are forecasted to grow at a higher rate during this period. However,
the growth rate is assumed to eventually stabilize as the company matures and reaches a
more sustainable level of growth in the stable growth stage.
In the Multi-Stage DCF Model, the forecast period is divided into multiple stages, each
with its own growth rate. This approach allows for a more flexible and nuanced analysis
of the company’s growth prospects, accommodating fluctuations in growth rates over
time. The model may include an initial high-growth phase, followed by one or more
intermediate growth stages, and eventually transition into a stable growth phase. Each
stage reflects different assumptions about the company’s growth drivers, competitive
landscape, and industry dynamics.
Both the Two-Stage and Multi-Stage DCF Models require careful consideration of various
factors, including revenue drivers, operating margins, capital expenditures, and discount
rates. In the initial high-growth stage, revenue growth is typically driven by factors such
as market expansion, product innovation, or strategic partnerships. However, as the
company matures, revenue growth is expected to moderate, leading to a more stable and
predictable growth trajectory in the stable growth stage.
Key challenges in implementing these models include accurately forecasting future cash
flows and selecting appropriate discount rates for each stage of growth. Analysts must
also consider the potential risks and uncertainties associated with the company’s business
model, competitive position, and macroeconomic factors. Sensitivity analysis and scenario
testing are often employed to assess the impact of different assumptions on the valuation
outcome and mitigate potential valuation errors.
Two-Stage DCF Model and Multi-Stage DCF Model offer sophisticated frameworks for
valuing companies with dynamic growth profiles. By incorporating different stages
of growth and applying appropriate assumptions and discount rates, these models
provide valuable insights into the intrinsic value of a company’s stock or business,
helping investors make informed investment decisions in dynamic and evolving
markets.

CHECK YOUR PROGRESS – I

1. The Two-Stage DCF Model breaks down the forecast period into _________ stages.
(a) One
(b) Two
(c) Three
(d) Four
2. In the Multi-Stage DCF Model, each stage of the forecast period may have its own
_________.
(a) Growth rate
304 (b) Discount rate
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(c) Revenue target NOTES
(d) Profit margin
3. The Two-Stage DCF Model assumes that the growth rate will eventually _________
in the stable growth stage.
(a) Accelerate
(b) Stabilize
(c) Decline
(d) Remain constant
4. The Multi-Stage DCF Model is suitable for companies with consistent and stable
growth prospects.
(a) True
(b) False
5. In the Two-Stage DCF Model, revenue and earnings are forecasted to grow at a
higher rate during the stable growth stage.
(a) True
(b) False

12.2 TWO-STAGE DCF VALUATION

The two-stage model of DCF Valuation accommodates more than one growth rate for
a business. Generally, businesses do not experience a stable growth rate throughout
its life in the ever-changing market. Hence to address the same, we use the two-stage
model for a business shifting from its growth stage with a high growth rate to the
maturity stage with a stable growth rate, the growth rate of the cash flow changes and
then remains stable for the perpetual life of the business. Hence the DCF is calculated
in two stages.
Stage one is to ascertain the Present value of FCFF for the high-growth period
¥ æ FCFF ÷ö
PV(FCFF) = å t =1 çç ÷
çè (1 + wacc)t ÷÷ø

Stage two is to ascertain the value of the firm for the rest of its perpetual life
FCFt (1 + g )
FCFP =
wacc - g
And then discounting the value to find out its present value
FCFP
PVFCFP =
(1 + wacc)t
The value of the firm will be equal to the present value of the FCFF in the high growth
stage and the present value of free cash flow in the stable growth period.
Value of the firm = PV(FCFF) AFP + PVFCFP
305
Let us understand this with the help of an example.
UNIT 12
Business Valuation – DCF Model II
NOTES Example 1:
Ajanta Limited is a growing company with a current growth rate of 15% which is
estimated to be growing at this rate for the next five years post which the stable growth
rate is 10% for its remaining life. The current financial details for the company are as
follows:
Table 12.1: Current Financial Details of Ajanta Limited

Particulars Amount (Rs.)

EBIT Rs. 1200 Crores
Depreciation Rs. 110 Crores
Long term Investment Rs. 200 Crores
Working capital as a percentage of EBIT 20%
Corporate Tax Rate 30%
Weighted Average Cost of Capital 12%
Growth Rate of the company during the growth period 15%
Stable Growth Rate post the growth period 10%

The EBIT, Depreciation, and long-term investment are assumed to grow at the same
rate as the company. Find the value of Ajanta Limited using the Two-stage model of DCF
Valuation.
The first step is to forecast the financial elements needed to estimate the FCFF for the
period of the next five years.
Table 12.2: EBIT, Depreciation, and long-term investment of Ajanta Limited

Particulars 1 2 3 4 5
EBIT 1380.00 1587.00 1825.05 2098.81 2413.63
Depreciation 126.50 145.48 167.30 192.39 221.25
Long term Investment 230.00 264.50 304.18 349.80 402.27
Working Capital 276.00 317.40 365.01 419.76 482.73

Let us calculate the free cash flow available to the firm (FCFF)

Table 12.3: Calculation of free cash flow available to the firm (FCFF)

Particulars 1 2 3 4 5
EBIT 1380.00 1587.00 1825.05 2098.81 2413.63
EBIT (1 - t) 966.00 1110.90 1277.54 1469.17 1689.54
Add: Depreciation 126.50 145.48 167.30 192.39 221.25
Less: Changes in Long term 30.00 34.50 39.70 45.60 52.48
Investment
Less: Changes in Working 36.00 41.40 47.61 54.75 62.96
Capital
306
Free Cash flow to the firm (FCFF) 1026.50 1180.48 1357.52 1561.20 1795.35
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 FCFF  NOTES
∑
∞
PV (FCFFF ) = t =1  t 
 (1 + wacc) 
1026.50 1180.48 1357.52 1561.20 1795.35
= + + + +
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5
1 2 3 4

= 916.52 + 941.07 + 966.25 + 992.17 + 1018.73

= Rs. 4834.74

FCFt (1 + g )
FCFP =
wacc - g
1018.73(1 + 0.10)
=
0.15 - 0.10
= Rs. 22412.06

FCFP
PVFCFP = t
(1 + wacc )
22412.06
= 5
(1 + 0.12)
= Rs. 12717.20
Value of the firm = PV(FCFF) AFP + PVFCFP
= 4834.74 + 12717.20
= Rs. 17551.94

CHECK YOUR PROGRESS – II

1. The two-stage model assumes that the business has two stages of growth rate.
(a) True
(b) False
2. A firm assumes that it expects a high growth rate of 15% for the next 6 years and
then a stable growth rate of 10% for perpetuity. The free cash flow available for
perpetuity will be discounted for a period of
(a) 7 years
(b) 6 years
(c) Perpetuity
(d) It will not be discounted
3. In the two-stage model, the discounting rate in the first stage is the weighted
average cost of capital and in the second stage, discounting rate is the cost of equity.
(a) True
(b) False
307
UNIT 12
Business Valuation – DCF Model II
NOTES 4. The discounted Cash flow method assumes that the business will not run for
perpetuity.
(a) True
(b) False

12.3 MULTI-STAGE DCF VALUATION

In today’s fast-changing world, every day a new firm or start-up is popping up with great
potential. Some of these companies have a very promising start with the growth rate
reaching as high as 30% to 40%. Such companies enjoy this growth spurt for some time,
then the growth rate gradually decreases to the high growth rate of around 20%-25%,
which further declines to a stable growth rate at which the company continues for the
rest of its life. For such companies, the valuation is done using the three-stage model or
multi-stage model based on varying growth rates. Hence for a rapidly growing company,
the DCF Valuation is done based on their growth rate in different stages. With 3 stages of
growth, we employ the three-stage model of DCF Valuation and with the business having
more than 3 stages of growth the multistage DCF Valuation is used.
Let us understand the multi-stage model with the help of a hypothetical example:
Example 2:
Unicorn Ltd is a start-up which has given out the following details. The Free cash flow
available to the firm in the first year of the forecast period is Rs. 140 crores, which is
expected to grow as per the growth rate of the company. Calculate the stage of DCF
Valuation
Table 12.4: Calculation of Stages of DCF Valuation

Particulars Growth Spurt High Growth Transition Period Stable growth rate
Growth Rate 25% 20% 15% 10%
Period of 3 years 3 years 2 years Forever
Growth
Wacc 12% 12% 12% 12%

Here there are 4 stages of growth, hence the value of the firm as per the multistage model
will be calculated as
PVFCFStage1 + PVFCFStage2 + PVFCFStage3 + PVFCFStage4
Let’s begin the calculation of the present value stage-wise. It is mentioned that the FCFF
expected for year 1 is Rs. 140 crores which will further grow at the rate of 25% per annum
for the next three years

∞ æ FCFF ÷ö
PVFCFStage 1 = å t =1 çç ÷
çè (1 + wacc)t ÷ø
140 175 218.75
=
(1 + 0.12) (1 + 0.12) (1 + 0.12)3
1 2

= 125 + 139.51 + 155.70

308
= Rs. 420.21
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The FCFF for year 4 will be equal to the FCF of 3rd Year growing at a 20% growth rate per NOTES
annum for the next three years
FCCFF 
∑
∞
PVFCFStage 2 = t =1  t 
 (1 + wacc) 
262.5 315 378
=
(1 + 0.12) (1 + 0.12) (1 + 0.12)6
4 5

= 166.82 + 178.74 + 191.51

= Rs. 537.07
The third stage is the transition stage with a growth rate of 15%, the FCFF for the 7th Year
will equal the FCFF in the 6th Year growing at the rate of 15%
 FCCFF 
∑
∞
PVFCFStage 3 =
t =1  t 
 (1 + wacc) 
434.7 499.91
=
(1 + 0.12) (1 + 0.12)8
7

= 196.64 + 201.91
= Rs. 398.55
Stage four is the perpetual stage with a constant growth rate hence the present value of
cash flow will be
FCFt (1 + g) 1
PVFCF
= Stage 4 ×
wacc – g (1 + wacc)t
499.91(1 + 0.10) 1
=
0.12 – 0.10 (1 + 0.12)8
= Rs. 11104.79
Hence the value of the firm is = PVFCFStage1 + PVFCFStage2 + PVFCFStage3 + PVFCFStage4
= 420.21 + 537.07 + 398.55 + 11104.79
= Rs. 12460.62

12.3.1 SENSITIVITY ANALYSIS

The discounted cash flow model is popular since it can integrate best-case and worst-
case scenarios to find out its impact on the cash flow. Since DCF can highly be influenced
by changes in growth rate, changes in capital structure, major capital expenditure in the
future, etc, it is important to create different scenarios of the same and interpret how each
variable can have an impact on the DCF Value of the firm. This is termed as the sensitivity
analysis in DCF Valuation. The sensitivity analysis is a financial modelling tool that examines
the impact of varying independent variable values on a certain dependent variable under
specific assumptions. This can be done by undertaking the following procedure:
• Define the objective of valuation – It is vital to know for what purpose are you
evaluating the value of the firm, whether it is for shareholders, for the whole firm,
for the sale of a business, or the sale of part of the business. Based on this varying
309
purpose you need to find the key drivers for the DCF valuation.
UNIT 12
Business Valuation – DCF Model II
NOTES • Key drivers – In the case of mergers and acquisitions lot of external factors will
affect the valuation of the business, like the market price of the share, and the
sentiments of the employees towards the acquisition, which can affect the key
drivers of the company like the growth in the cash flow, the capital structure of
the company which can further affect the cost of capital. Hence identifying the key
variables that can influence the cash flow of the company based on the objective
of valuation needs to be carried out.
• Create Scenarios – The evaluation of the best-case and worst-case scenarios
needs to be created based on how bad or good the key drivers can vary. This
gives a range of DCF valuations between which we can expect the value of the
firm to move. Hence, we can create multiple scenarios that can integrate the
different valuations we can predict based on any uncertainty that may occur in
the future.
• Analyse the scenario – Once various scenarios are created, we will be able
to understand which are the most sensitive variables for the firm and how
they can impact the value of the firm, we may also take precautionary action
wherever possible to mitigate the negative impact of key drivers on the value
of the firm.
Let us understand why the Discounted Cash flow model is the most preferred model for
business valuation:
Some Advantages of DCF Valuation over other techniques are listed below:
• The discounted cash flow model is the only method that focuses on the return on
investment. It is based on the projected cash flow of the firm which is discounted
at the weighted average cost of capital of the firm. Hence it is highly reliable.
• It is an internationally accepted method since data for the evaluation is readily
available or can be projected without much of a hassle.
• This method is extremely detailed and can integrate different growth rates of a
company.
• It’s useful in estimating the Company’s intrinsic value, or the value of equity of
the firm.
• This method considers the time value of money and hence the valuation done is
in real money terms.
• Multiple scenarios can be built in this method hence very helpful for a company
surviving in an ever-changing market.
• Room for sensitivity analysis is available in this method.
• Unlike other approaches to business valuation this method can also be used by
companies that are not traded in the stock market or where the information of the
competitors is not readily available. Used to calculate the IRR.

12.3.2 PRECAUTIONS FOR BUSINESS VALUATION

• Business valuation is a highly technical concept based on various assumptions, so
relying on one single method of valuation will not be fruitful. Hence it is always
recommended that the valuation of business is done using multiple models.
310 • The valuation of business is greatly subjective so it is recommended to use your
practical wisdom and expert advice before concluding the valuation.
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• Business valuation is based on numbers derived from the financial statements. NOTES
It is always important not to ignore the qualitative aspects of the business which
are not reflected in the evaluation of the business.
• Business evaluation needs to consider external factors that might affect the
business in the future, like the geopolitical environment, legal regulations, and
nature of competition before concluding the valuation.
• Many times, business ignores the intangible assets of the business which are not
reflected in its financial statement. All the assets and liabilities including major
investment planned in the future needs to be considered.
• In the everchanging environment it is difficult to Forecast the cash flow of the
future hence it is advisable to keep a shorter absolute forecast period in case of
risky business.
• It is also important to understand the business valuation once done is not timeless
and it needs to be amended according to changing business environment.

12.4 CASE STUDY ON DCF VALUATION

12.4.1 CASE STUDY OF SYNERGY TECH SOLUTIONS
Synergy Tech Solutions is a technology company specializing in software development
and IT consulting. The company has been in operation for the past 10 years, providing
innovative solutions to a diverse range of clients across various industries.
Synergy Tech Solutions is considering strategic decisions for the future, including potential
mergers, acquisitions, or seeking external investment. To assess the company’s intrinsic
value, the management has decided to conduct a Discounted Cash Flow (DCF) valuation.

DATA COLLECTION
HISTORICAL FINANCIALS
• Revenue = Rs 225 million
• Revenue Growth (past 5 years): 10% annually
• EBIT Margin: 15%
• Capital Expenditure (CapEx): I20 million per annum
• Depreciation: I15 million per annum
• Tax Rate: 25%

FUTURE ASSUMPTIONS
• Forecasted Revenue Growth (next 5 years): 8% annually
• Estimated Terminal Growth Rate: 5%
• Weighted Average Cost of Capital (WACC): 12%

DCF VALUATION
1. Free Cash Flow (FCF) Calculation:
FCF = EBIT × (1 - Tax Rate) + Depreciation − CapEx
FCF = (Revenue × EBIT Margin) × (1 - Tax Rate) + Depreciation − CapEx 311
UNIT 12
Business Valuation – DCF Model II
NOTES Year 1:
Revenue1 = Revenue0 × (1 + Revenue Growth)
EBIT1 = Revenue1 × EBITDA Margin
FCF1 = (EBIT1 × (1 - Tax Rate)) + Depreciation – CapEx

Year 2:
Revenue2 = Revenue1 × (1 + Revenue Growth)
EBIT2 = Revenue2 × EBITDA Margin
FCF2 = (EBIT2 × (1 - Tax Rate) + Depreciation – CapEx
Year 3:
Revenue3 = Revenue2 × (1 + Revenue Growth)
EBIT3 = Revenue3 × EBITDA Margin
FCF3 = (EBIT3 × (1 - Tax Rate)) + Depreciation – CapEx

Year 4:
Revenue4 = Revenue3 × (1 + Revenue Growth)
EBIT4 = Revenue4 × EBITDA Margin
FCF4 = (EBIT4 × (1 - Tax Rate)) + Depreciation – CapEx
Year 5:
Revenue5 = Revenue4 × (1 + Revenue Growth)
EBIT5 = Revenue5 × EBITDA Margin
FCF5 = (EBIT5 × (1 - Tax Rate)) + Depreciation – CapEx

Let’s plug in the values and calculate:

Revenue1 = (1 + 0.10) × Revenue0
EBIT1 = Revenue1 × 0.15
FCF1 = (EBIT1 × 0.75) + 15 - 20
Revenue2 = (1 + 0.10) × Revenue1
EBIT2 = Revenue2 × 0.15
FCF2 = (EBIT2 × 0.75) + 15 - 20
Revenue3 = (1 + 0.10) × Revenue2
EBIT3 = Revenue3 × 0.15
FCF3 = (EBIT3 × 0.75) + 15 - 20
Revenue4 = (1 + 0.10) × Revenue3
EBIT4 = Revenue4 × 0.15
312
FCF4 = (EBIT4 × 0.75) + 15 - 20
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Revenue5 = (1 + 0.10) × Revenue4 NOTES
EBIT5 = Revenue5 × 0.15
FCF5 = (EBIT5 × 0.75) + 15 - 20
2. Discounted Cash Flow Calculation:

 FCFt  Terminal Value

=DCF ∑  (1 + WACC ) +
t
 (1 + WACC )
T

FCTT +1 × (1 + Terminal Growth Rate)

Terminal value =
WACC – Terminal Growth Rate
Free Cash Flow Projection (in K million):
• Year 1: I150
• Year 2: I170
• Year 3: I190
• Year 4: I210
• Year 5: I230
Discounted Cash Flow (in K million):
• Present Value of FCF (Year 1-5): I813.56
• Present Value of Terminal Value: I1,555.56
• Total DCF: I2,369.12

CONCLUSION
Based on the DCF valuation, the intrinsic value of Synergy Tech Solutions is estimated to
be I2,369.12 million. This valuation provides crucial insights for decision-making regarding
potential investments, mergers, or acquisitions. It is essential to recognize the sensitivity
of the valuation to changes in key assumptions, such as the discount rate and growth
rates, to make informed strategic decisions. The management can use this DCF analysis
to negotiate favorable terms in potential transactions and communicate the company’s
value proposition to potential investors or acquirers.

12.4.2 VALUTION OF AMAZON LTD.

The following is the forecasted value for AMAZON Ltd. The prediction for base-case, best-
case, and worst-case scenarios. Assess the DCF Valuation of the company

Table 12.5: Forecasted Value for AMAZON Ltd

Base Case Year 1 Year 2 Year 3 Year 4 Year 5 Terminal

Value
Forecasted Forecasted Forecasted Forecasted Forecasted Forecasted
Revenue 612 676 761 848 912 947
Operating 4.78% 6.13% 7.67% 7.66% 7.65% 7.64%
Margin
313
(Continues)
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Business Valuation – DCF Model II
Table 12.5: Forecasted Value for AMAZON Ltd (Continued)
NOTES
Base Case Year 1 Year 2 Year 3 Year 4 Year 5 Terminal
Value
Forecasted Forecasted Forecasted Forecasted Forecasted Forecasted
Operating 29 41 58 65 70 72
Income (EBIT)
Taxes 2 4 7 10 13 15
WACC 8.18% 8.18% 8.18% 8.18% 8.18% 8.18%
Best Case Year 1 Year 2 Year 3 Year 4 Year 5 Terminal
Value
Forecasted Forecasted Forecasted Forecasted Forecasted Forecasted
Revenue 651 716 846 972 1 079 1 157
Operating 5.64% 7.92% 11.03% 10.98% 10.93% 10.87%
Margin
Operating 37 57 93 107 118 126
Income (EBIT)
Taxes –2 –5 –11 –17 –22 –28
WACC 7.77% 7.77% 7.77% 7.77% 7.77% 7.77%
Worst Case Year 1 Year 2 Year 3 Year 4 Year 5 Terminal
Value
Forecasted Forecasted Forecasted Forecasted Forecasted Forecasted
Revenue 550 605 679 753 800 812
Operating 3.60% 5.15% 5.30% 5.30% 5.30% 5.30%
Margin
Operating 20 31 36 40 42 43
Income (EBIT)
Taxes –1 –1 –1 –8 –8 –8
WACC 8.59% 8.59% 8.59% 8.59% 8.59% 8.59%
Source 1 https://www.alphaspread.com/security/nasdaq/amzn/dcf-valuation/base-case

Evaluate the value of the company in the base-case, best-case, and worst-case scenario
and compare it with the market price of the share of the company. Interpret the result.

12.4.3 SOLVED EXAMPLES

1. Calculate the FCFF and FCFE for the Absolute Forecast Period for Pinnacle
Ltd. with the following information. The current growth rate of 12% which is
estimated to be growing at this rate for the next 10 years. The EBIT, borrowings,
and Long-term investment are assumed to grow at a current growth rate of
the company, while the depreciation is 10% of the long-term investment and
interest is 8% of the borrowings. The current financial details for the company
314 are as follows:
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Particulars Amount (Rs.) NOTES

EBIT Rs. 40,000
Depreciation Rs. 2000
Long term Investment Rs. 20,000
Borrowings Rs. 10,000
Working capital as a percentage of EBIT 15%
Corporate Tax Rate 25%
Weighted Average Cost of Capital 15%
Growth Rate of the company during the absolute forecast period 12%
Cost of Equity 17%

Solution:
Sr. No. Particulars 1 2 3 4 5 6 7 8 9 10
EBIT 44800 50176 56197.12 62940.77 70493.67 78952.91 88427.26 99038.53 110923.2 124233.9
A EBIT (1 – t) 33600 37632 42147.84 47205.58 52870.25 59214.68 66320.44 74278.9 83192.36 93175.45
Long term investment 22400 25088 28098.56 31470.39 35246.83 39476.45 44213.63 49519.26 55461.58 62116.96
B Add: Depreciation 2240 2508.8 2809.856 3147.039 3524.683 3947.645 4421.363 4951.926 5546.158 6211.696
C Less: Changes in Long term Invest 2400 2688 3010.56 3371.827 3776.446 4229.62 4737.174 5305.635 5942.312 6655.389
Working Capital 6720 7526.4 8429.568 9441.116 10574.05 11842.94 13264.09 14855.78 16638.47 18635.09
D Less: Changes in Working Capital 720 806.4 903.168 1011.548 1132.934 1268.886 1421.152 1591.691 1782.693 1996.617
Free Cash flow to the firm (FCFF) 32720 36646.4 41043.97 45969.24 51485.55 57663.82 64583.48 72333.5 81013.52 90735.14
(A+B-C-D)
Present value of FCFF 28452.17 27709.94 26987.08 26283.06 25597.42 24929.66 24279.32 23645.95 23029.09 22428.34

Value of Pinnacle Ltd for the absolute period will be FCFF – Rs. 253342 (Sum of the present
value of FCFF for the ten years)

Table 12.6: Tables Showing Calculation of FCFF and FCFE for the Absolute Forecast Period for Pinnacle Ltd

Sr. No. Particulars 1 2 3 4 5 6 7 8 9 10

EBIT 44800 50176 56197.12 62940.77 70493.67 78952.91 88427.26 99038.53 110923.2 124233.9
A EBIT (1 – t) 33600 37632 42147.84 47205.58 52870.25 59214.68 66320.44 74278.9 83192.36 93175.45
Borrowings 11200 12544 14049.28 15735.19 17623.42 19738.23 22106.81 24759.63 27730.79 31058.48
Interest 896 1003.52 1123.942 1258.815 1409.873 1579.058 1768.545 1980.771 2218.463 2484.679
B Interest (1 – t) 672 752.64 842.9568 944.1116 1057.405 1184.294 1326.409 1485.578 1663.847 1863.509
Long term investment 22400 25088 28098.56 31470.39 35246.83 39476.45 44213.63 49519.26 55461.58 62116.96
C Add: Depreciation 2240 2508.8 2809.856 3147.039 3524.683 3947.645 4421.363 4951.926 5546.158 6211.696
D Less: Changes in Long term Invest 2400 2688 3010.56 3371.827 3776.446 4229.62 4737.174 5305.635 5942.312 6655.389
Working Capital 6720 7526.4 8429.568 9441.116 10574.05 11842.94 13264.09 14855.78 16638.47 18635.09
E Less: Changes in Working Capital 720 806.4 903.168 1011.548 1132.934 1268.886 1421.152 1591.691 1782.693 1996.617
F Changes in Net Borrowings 1200 1344 1505.28 1685.914 1888.223 2114.81 2368.587 2652.818 2971.156 3327.695
Free cash flow to the Equity (FCFE) 33248 37237.76 41706.29 46711.05 52316.37 58594.34 65625.66 73500.74 82320.82 92199.32
(A-B+C-D-E+F)
Present Value of FCFE 28.417.09 27228.98 26040.18 24927.35 23862.08 22842.34 21866.17 20931.72 20037.19 19180.91

315
UNIT 12
Business Valuation – DCF Model II
NOTES Value of Equity of Pinnacle Ltd for the absolute period will be FCFE – Rs. 206916.9 (Sum of
the present value of FCFE for the ten years)
2. Assuming Pinnacle Ltd estimates that after 10 years, the firm will achieve a stable
growth rate of 9% for its remaining perpetual life. Evaluate the value of the firm
and the value of equity of the firm using the DCF Model.
Solution:
Value of the firm = PV(FCFF) AFP + PVFCFP
Since we have already evaluated the Present value of the firm for the absolute
period in question 1, we will now evaluate the Present value of the free cash
flow to the firm for its remaining perpetual life.
FCFt (1 + g) 1
PVFCFP
= ×
wacc – g (1 + wacc)t
22428.34 (1 + 0.09) 1
= ×
0.15 – 0.19 (1 + 0.15)10
= Rs. 100714.96
Value of the firm = PV(FCFF) AFP + PVFCFP
= 253342 + 100714.96
= Rs. 354056.96

Value of Equity = Present Equity Value for the absolute forecasting period + PVFCFEP

19180.91 (1 + 0.09) 1
206916.9 +
= ×
0.17 – 0.9 (1 + 0.17)10
= 206916.9 + 54368.47
= Rs. 261285.37

3. Zenith Ltd is a start-up which has given out the following details. The Free cash
flow available to the firm in the first year of the forecast period is Rs. 1200 crores,
which is expected to grow as per the growth rate of the company. Calculate the
Multi-stage DCF Valuation of the firm.

Table 12.7: Financial Details of Zenith Ltd

Particulars Growth Spurt High Growth Transition Period Stable growth rate
Growth Rate 22% 18% 15% 12%
Period of Growth 4 years 3 years 3 years Forever
WACC 14% 14% 14% 14%

Solution:

Present Value for Stage 1 – Rs. 4693.63,

Present Value for Stage 2 – Rs. 3910.54,
316
Present Value for Stage 3 – Rs. 4367.84,
 FINE005
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Present Value for Stage 4 – Rs. 98171.21 NOTES
Value of the firm = Rs. 111143.22

CHECK YOUR PROGRESS – III

1. The DCF can integrate a maximum of three growth stages for the evaluation of the
business. True or False
(a) True
(b) False
2. Once the DCF valuation is done with the proper method, it is timeless and need not
be re-evaluated. True or False
(a) True
(b) False
3. DCF Valuation is based on estimation and forecasted value.
(a) True
(b) False

12.5 LET US SUM UP

• To accommodate the different levels of growth the DCF Valuation can be classified
as the Single-stage DCF, Two-stage DCF, and Multi-stage DCF Valuation Model.
Each of these models comprises the Absolute forecast period and the remaining
perpetual life.
• The absolute forecast period is the period for which the projection of financial
statements can be done, ranging from 3,5 to 10 years. Since the business is assumed
to go on forever the remaining life of the business is considered to be infinity.
• DCF valuation is a very versatile model that can be calculated keeping in mind different
scenarios of business, also known as the sensitivity analysis.
• The discounted Cash flow technique is considered superior to other techniques as it is
based on projected cash flow and not on the market price of its share or competitors’
valuation.
• Even with so many benefits of using the DCF valuation, one needs to be cautious while
conducting business valuation and keep in mind business valuation is not timeless and
needs to be done with utmost care.
• The qualitative aspects and the intangible assets generally ignored should be
considered during valuation.

12.6 KEYWORDS
Multi-stage model: The DCF Valuation model is done in multiple stages based on the
differing growth rate in each stage of the business.
Perpetual life: The business is considered as a separate legal entity that has an infinite life.
The projection of financial statements can be done for a shorter duration, which is termed
as the absolute forecast period and the remaining life of the business is in this chapter 317
termed as its perpetual life.
UNIT 12
Business Valuation – DCF Model II
NOTES PVFCF: The Present Value of the Free cash flow is the value of the projected cash flow in
the future of a business discounted at the weighted average cost of capital.
Time value of money: The time value of money states that the value of a rupee today is
worth more than the value of a rupee in the future. This is the reason that all future cash
flows are discounted to find out the worth of that cash flow today.
Two-stage Model: The DCF Valuation model is used when the business is expected two
growth rate stages in the future period.

12.7 REFERENCES AND SUGGESTED ADDITIONAL READINGS

REFERENCES
1. Damodaran A. (2012). Investment Valuation. John Wiley & Sons
2. Chandra P. Financial Management. 10th Edition. McGraw Hill
3. Kruschwitz L, Loffler A. Discounted Cash flow: A theory of Valuation of the firm.
Wiley Finance
4. Christy G, C. Free Cash flow. Wiley Finance Series

SUGGESTED ADDITIONAL READINGS

1. Damodaran A. (2011) The Little Book of Valuation: How to Value a Company, Pick a
Stock and Profit. Wiley
2. Shapiro E., Mackmin D, Sams D., (2019) Modern Method of Valuation. 12th Edition.
Estates Gazette.
3. Titman S., Valuation: The art and science of corporate investment Decision. (2022)
3rd Edition. Pearson Education

12.8 SELF-ASSESSMENT QUESTIONS

1. In the initial high-growth stage, revenue growth is primarily fueled by _________.
(a) Cost reduction initiatives
(b) Market contraction
(c) Product innovation
(d) Economic recession
2. What is one of the key challenges in implementing the Two-Stage and Multi-Stage
DCF Models?
(a) Identifying current market trends
(b) Analyzing historical financial data
(c) Accurately forecasting future cash flows
(d) Conducting competitor analysis
3. What distinguishes the Single-stage, Two-stage, and Multi-stage DCF Valuation Models?
318 (a) The number of cash flow projections
(b) The discount rate used
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(c) The absolute forecast period and perpetual life NOTES
(d) The type of industry being valued
4. Why is the discounted cash flow (DCF) technique considered superior to other
valuation techniques?
(a) It is based on market price of shares
(b) It relies on competitors’ valuation
(c) It is based on projected cash flow
(d) It incorporates qualitative aspects only
5. Why is it recommended to use multiple valuation models when valuing a business?
(a) It simplifies the valuation process
(b) It increases the subjectivity of the valuation
(c) It allows for a more comprehensive assessment
(d) It reduces the need for expert advice
6. What is a key recommendation when conducting business valuation?
(a) Rely solely on one valuation method
(b) Avoid seeking expert advice
(c) Utilize practical wisdom and expert advice
(d) Conduct the valuation in isolation
7. The sensitivity analysis in DCF is done to evaluate
(a) How sensitive the business is, concerning its earnings
(b) the best-case and worst-case scenario
(c) the key drivers of the business
(d) All of the above
8. The Discounted Cash flow method is also known as the
(a) Intrinsic Valuation
(b) Extrinsic Valuation
(c) Relative Valuation
(d) Market Valuation
9. Sensitivity analysis helps to evaluate the value of the business in both best case and
worst-case scenario
(a) True
(b) False
10. What caution should be exercised when conducting business valuation using the
DCF method?
(a) Ignoring qualitative aspects 319
(b) Relying solely on market price
UNIT 12
Business Valuation – DCF Model II
NOTES (c) Considering valuation as timeless
(d) Incorporating intangible assets

12.9 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

Check Your Progress – I
1. (b)
2. (a)
3. (b)
4. (b)
5. (b)

Check Your Progress – II

1. (a)
2. (b)
3. (b)
4. (b)

Check Your Progress – III

1. (b)
2. (b)
3. (a)

12.10 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (c) 3. (c) 4. (c) 5. (c)
6. (c) 7. (d) 8. (a) 9. (a) 10. (c)

320
 UNIT 13
RELATIVE VALUATION

STRUCTURE
13.0 Objectives
13.1 Introduction
13.2 What is Relative Valuation
13.3 Types of Relative Valuation
13.4 Multiples
13.5 Price Earning Multiples
13.6 Book Value Multiples
13.7 Enterprise Value Multiple
13.8 Sector Specific Multiples
13.9 Advantages of Relative Valuation
13.10 Disadvantages of Relative Valuation
13.11 Let Us Sum Up
13.12 Keywords
13.13 References and Suggested Additional Reading
13.14 Self-Assessment Questions
13.15 Check Your Progress – Possible Answers
13.16 Answers to Self-Assessment Questions

13.0 OBJECTIVES
After reading this unit, you will be able to:
1. understand the concept of relative valuation and types of relative valuation
models.
2. describe the concept of multiple and various types of multiples.
3. understand various earning multiples their application.
4. understand book value multiples and their application.
5. understand enterprise value multiples their application.
6. understand the advantages and disadvantages of relative valuation. 321
UNIT 13
Relative Valuation
NOTES RECAP OF UNIT 12
From the previous unit, we have learnt that the DCF (Discounted Cash Flow) model is a
valuation technique employed to assess the worth of an investment by considering its
projected future cash inflows. The process entails predicting future cash flows, using a
discount rate to include the concept of time value of money, and computing the current
value of these cash flows to ascertain the inherent value of the investments. Discounted
Cash Flow (DCF) is a process used by investors to assess the appeal of an investing
opportunity by calculating the current value of future cash flows. Nevertheless, it is largely
reliant on the precision of cash flow estimates and the selected discount rate, rendering it
susceptible to fluctuations in both factors.

13.1 INTRODUCTION
In this Unit, we will comprehend the idea of relative valuation. Relative valuation is a
fundamental concept within the field of finance that serves as a cornerstone for assessing
the worth of assets, securities, and companies. Comparing the worth of an asset to similar
assets in the market helps analysts, investors, and financial experts determine the item’s
value. Analyse an asset’s cash flow, risk, and growth characteristics to determine its value.
Discounted cash flow (DCF) valuation aims to achieve this. However, it is a complex and
time-consuming process incorporating numerous highly subjective assumptions. Relative
valuation involves defining the worth of an asset by comparing its price to that of similar
assets in the market.
Therefore, we need to know that the relative valuation consists of two components.
One key aspect is the need to standardise asset values on a comparative basis, typically
achieved by translating prices into multiples of a shared variable. Although the specific
nature of this common variable may differ across different assets, it often manifests as
book value, earnings, and revenues for publicly traded companies.
Finding comparable companies is the second goal of relative valuation, which is difficult
because no two businesses are the same. It can be challenging to determine the value
of shares of companies within the same industry because of differences in risk, growth
potential, and cash flows. When comparing a wide range of variables across numerous
organisations, the question of how to account for these changes becomes vital.
We must acknowledge that, despite relative valuation’s ease of use and intuitive nature,
it can occasionally be abused. Relative valuation models are an alternative to absolute
value methods. Absolute value models estimate future free cash flows of a business and
discount them to their present value in order to calculate its intrinsic value. They do this
without comparing the business’s projected value to the industry average or to the worth
of any other company. Similar to absolute value models, relative valuation models help
investors decide if a company’s stock is a good investment. The relative value technique
evaluates an object’s worth in relation to other like objects by comparing their shared risk,
return, and salient features. We must acknowledge that relative value can occasionally be
abused despite its ease of use and intuitive nature. There are models of relative valuation
as an alternative to absolute value models.

13.2 WHAT IS RELATIVE VALUATION

322
Till now you have understood that the concept of Relative valuation involves assessing
the worth of an asset by comparing its price to that of comparable assets in the market.
 FINE005
Financial Analysis and
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The conventional method of relative valuation entails comparing a company’s valuation NOTES
multiple with that of its industry peers in order to determine if it is overpriced or
underpriced. For instance, a potential homebuyer determines the appropriate amount to
offer for a house by examining the prices that have been paid for comparable residences
in the vicinity.
In the relative valuation approach, an analyst determines the worth of a common share
by multiplying it with a certain metric, such as earnings per share (EPS) or sales per share.
The multiple is calculated by considering the price and the appropriate metric for publicly
traded, similar equity securities.
We need to understand that the fundamental premise of the relative valuation technique
is that common shares of companies exhibiting comparable levels of risk and return should
possess similar prices. Relative valuation is based on the utilisation of price multiples of
comparable companies that are publicly listed or an average for the industry.
In order to perform relative valuation,
1. It is necessary to find assets that are similar and acquire their market prices.
2. Transform these market values into standardised values, as direct price comparisons
are not feasible. Standardisation generates price multiples.
3. To assess if the asset being analysed is undervalued or overvalued, evaluate
its standardised value or multiple to the standardised values of comparable
assets, while considering any variations between the firms that could impact the
multiple.
Note: The example given is hypothetical.
Example: An investor is estimating the value of the common stock of XYZ company, Fast-
Moving Consumer Goods (FMCG) company, on a per share basis.
Analysts estimate that XYZ company will generate EPS of Rs. 15 next year.
The investor gathers information on three competing consumer durable players: A,B,C.
The investor calculates the P/E for each of the three companies.

Company Current Stock Price Earnings Per Share (EPS) P/E Ratio
A 1385 25 55
B 1220 23 53
C 800 25 32

The average P/E of three companies is (55 + 53 + 32)/3 = 47x

Thus, investor estimates the fair price of XYZ, on a per share basis should be not more
than is Rs. 705 i.e (47 × 15).
The average P/E ratio of these companies is calculated by adding the P/E ratios of each
company (55, 53, and 32) and dividing by the total number of companies (3), resulting in
an average P/E ratio of 47x.
To estimate the fair price of XYZ stock, the investor multiplies the average P/E ratio (47x)
by the earnings per share (EPS) of XYZ. In this case, the investor assumes that the EPS of
XYZ is Rs. 15. Therefore, multiplying the average P/E ratio (47) by the EPS (Rs. 15) yields a 323
fair price of Rs. 705 per share (47 × 15).
UNIT 13
Relative Valuation
NOTES This calculation suggests that, based on the average P/E ratio of comparable companies,
the fair price of XYZ stock should not exceed Rs. 705 per share. This approach provides
investors with a benchmark for valuing XYZ stock relative to its peers in the market, helping
them make more informed investment decisions.

CHECK YOUR PROGRESS – I

1. Investors can use a relative value to ascertain whether a stock is ______ or ______
relative to its peers.
2. Relative valuation compares the value of an asset to the values of ______ assets in
the market.
3. Which of the following statements is true regarding relative valuation?
(a) It provides an exact intrinsic value of an asset.
(b) It is independent of the market and economic conditions.
(c) It relies on comparing the asset to similar assets in the market.
(d) It requires complex mathematical models to calculate.
4. Relative valuation relies solely on the historical financial data of the assets being
compared.
(a) True
(b) False
5. Relative valuation is commonly used in the stock market to value individual stocks
and make investment decisions.
(a) True
(b) False

13.3 TYPES OF RELATIVE VALUATION

As we discussed in the previous section, Relative valuation techniques are utilised
to evaluate the value of organisations by comparing them to other businesses based
on specified factors. The two predominant kinds of relative value models include the
assessment of similar firms and the scrutiny of prior deals.

13.3.1 COMPARABLE COMPANY ANALYSIS

The process of valuing a firm by comparing its ratios to those of similar publicly traded
companies is known as “comps,” or comparable company analysis. The foundation
of comparable company research is the idea that companies with similar attributes
should have valuation multiples that are similar, such as EV/EBITDA. Analysts gather a
comprehensive set of facts for the firms under examination and compute the valuation
multiples to facilitate comparison. It begins by forming a peer group including firms
that are comparable in size and operate in the same sector or location. Investors
may thereafter assess and evaluate a certain firm in relation to its rivals, enabling a
comparative analysis.
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For Example, Price-Earning (PE) multiple is often used for assessing the worth of a NOTES
company’s stock vis-à-vis its peer firms. If the average PE of peer firms is 20 times
and the stock in consideration has EPS of Rs. 12 then fair price for the stock is arrived
as follows:

Justified Stock Price = Average PE Multiple × Stocks EPS

= 20 × 12 = Rs. 240

If the stock is trading above calculated fair price then it is considered to be overpriced
and vice-versa.

13.3.2 PRECEDENT TRANSACTION ANALYSIS

A valuation method used in investment banking to determine a company’s value
is precedent transaction analysis (PTA), also referred to as “Merger & Acquisition
Comps.” When estimating a company’s value, PTA looks back at previous prices paid
for similar businesses. PTA entails the collection of data from prior transactions,
Finding the most relevant transactions and Researching news announcements, equity
research papers, or other sources that provide transaction information. A primary
obstacle in using PTA is the scarcity of data on transactions that can be compared.
The availability of relevant transactions might vary according on the sector, market
conditions, and timeframe, perhaps resulting in a scarcity of suitable options or
incomplete and restricted data.
For example, if you want to value Company State Bank of India, you can compare it to the
transaction multiples of Canara Bank, HDFC Bank, and ICICI Bank that is comparison with
the other companies in the same industry.

CHECK YOUR PROGRESS – II

1. Relative valuation is a method of valuing assets based on their intrinsic characteristics
and cash flows.
(a) True
(b) False
2. In relative valuation, the goal is to determine the fair market value of an asset by
comparing it to similar assets within the same industry or sector.
(a) True
(b) False
3. In Comparable Company Analysis, the first step is to ____________, it entails picking
a set of peer businesses that the target business is comparable to.
4. To identify comparable companies, you typically consider factors such as industry,
size, geographic location, and ____________.
5. When using relative valuation, an analyst can assess the relative attractiveness of an
investment by comparing it to a relevant benchmark or index.
(a) True
(b) False 325
UNIT 13
Relative Valuation
NOTES 13.4 MULTIPLES
Now Let’s understand the concept of Multiples. Analysts commonly employ financial
ratios known as price multiples to evaluate and compare the relative valuations of various
firms. These measurements assess the market price of the company by comparing it
to fundamental indicators such as earnings, book value, and Enterprise Value. By using
a common metric, such earnings, cash flows, book value, or revenues, prices can be
standardised.
Earnings Multiples:
• Price/Earnings Ratio (PE): This ratio compares a company’s stock price to its
earnings per share (EPS), indicating how much investors are willing to pay for each
unit of earnings.
• Price/Earnings to Growth (PEG) Ratio: The PEG ratio factors in the company’s
growth rate, providing a more comprehensive measure of valuation by considering
both earnings and growth prospects.
• Relative PE: Relative PE compares a company’s PE ratio to those of its peers or the
overall market, helping to assess whether a stock is overvalued or undervalued
relative to its industry or the broader market.

Book Value Multiples:

• Price to Book Value (PBV) Ratio: PBV compares a company’s market value (market
capitalization) to its book value (shareholders’ equity), indicating how much
investors are paying for each unit of book value.
• Value/Book Value of Assets: This multiple assesses the company’s value in relation
to its tangible assets, such as property, plant, and equipment, providing insight
into the company’s asset utilization and efficiency.
• Value/Replacement Cost (Tobin’s Q): Tobin’s Q compares the market value
of a company to the replacement cost of its assets, offering a measure of
whether a company’s assets are undervalued or overvalued relative to their
replacement cost.

Metrics included in enterprise multiples include things like enterprise value to sales,
revenue, and EBITDA.
These multiples are used to assess whether the firm is fairly priced in comparison to peer
companies. If the earnings multiple of firm is much above the average PE of peer firms,
then it may indicate that firm is overpriced and vice-versa.

13.4.1 IMPORTANT STEPS TO NOTE WHILE APPLYING MULTIPLES

1. Defining the multiple: When being utilised, various users may describe the same
multiple in diverse manners. Take, for example, the price earnings ratio (PE),
which is the most commonly used measure in valuation. Analysts commonly
describe it as the ratio of the market price to the earnings per share, however
there is no unanimous agreement on this definition. Several variations of the PE
ratio exist. Although the prevailing price is typically employed as the numerator,
several analysts opt to utilise the mean price over the past six months or
326 one year. So, It is crucial that we comprehend the methodology behind the
 FINE005
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estimation of multiples when comparing and utilising them as determined by NOTES
another individual.
2. Describing the Multiple: When utilising a multiple, it is advantageous to possess
an understanding of the market’s high, low, or normal values for that particular
multiple. Put simply, understanding the distributional properties of a multiple is
crucial for utilising it as a tool to determine the undervaluation or overvaluation
of companies.
3. Analyzing the Multiple: It is essential to possess a comprehensive comprehension
of the underlying principles that influence each factor, as well as the nature of the
correlation between the factor and each variable.
4. Application of the Multiple: Implementing the process of defining the comparable
universe and mitigating disparities is considerably more challenging in practical
application than it is in theoretical understanding. For instance, multiples are
widely employed to assess a company’s or its shares’ value when comparing
them to other similar firms. Nevertheless, what criteria determine the
comparability of a firm? Although it is customary to examine companies
within the same industry or sector, this approach may not always be accurate.
Differences between the firm we are analysing and the selected comparable
firms will continue, even with our careful selection of such firms. Another
thing to think about is the overall condition of the market and the economy.
Macroeconomic factors, industry trends, and market opinion can all have
significant effect on multiples.

EXAMPLE OF MULTIPLES
Example I: Company X and Company Y, for a comparable company analysis using the
relative valuation method:

Company X:
• Market Capitalization: ₹1,000 crore
• Revenue (trailing twelve months): ₹200 crore
• Earnings (trailing twelve months): ₹50 crore
• Enterprise Value: ₹1,200 crore
• EBITDA (trailing twelve months): ₹80 crore

Company Y:
• Market Capitalization: ₹800 crore
• Revenue (trailing twelve months): ₹150 crore
• Earnings (trailing twelve months): ₹40 crore
• Enterprise Value: ₹1,000 crore
• EBITDA (trailing twelve months): ₹70 crore

Now, let’s calculate the valuation multiples:

Price-to-Earnings (P/E) Ratio:
• Company X: P/E = Market Cap/Earnings = ₹1,000 crore/₹50 crore = 20x 327
• Company Y: P/E = Market Cap/Earnings = ₹800 crore/₹40 crore = 20x
UNIT 13
Relative Valuation
NOTES Price-to-Sales (P/S) Ratio:
• Company X: P/S = Market Cap/Revenue = ₹1,000 crore/₹200 crore = 5x
• Company Y: P/S = Market Cap/Revenue = ₹800 crore/₹150 crore ≈ 5.33x

Enterprise Value-to-EBITDA (EV/EBITDA) Ratio:

• Company X: EV/EBITDA = Enterprise Value/EBITDA = ₹1,200 crore/₹80 crore = 15x
• Company Y: EV/EBITDA = Enterprise Value/EBITDA = ₹1,000 crore/₹70 crore ≈ 14.29x

These are the valuation multiples for Company X and Company Y based on the relative
valuation method.
Example II: Beta Company’s ROE is 18%, and its cost of equity is 15%. Beta’s dividend
payout ratio is 0.4 and its ploughback ratio is 0.6. So, from a fundamental point of view,
Fair price of stock as per dividend discount model is:
D1 (1 - b)E1 (1 - b)E1
P0 = = =
r - g -b ´ ROE r - ROE ´ b

Beta’s P/E multiple is calculated by dividing the above theoretical price by EPS:
(1 - b)
P0 / E1 =
r - ROE ´ b
where (1 – b) is the dividend payout ratio, r is the cost of equity, ROE is the return on
equity, and b is the ploughback ratio.

0.4
=P0 / E1 = 9.52
0.15 − 0.18 × 0.6

CHECK YOUR PROGRESS – III

1. When comparing a company’s valuation to that of other comparable businesses in
the same industry, multiples in relative valuation are employed.
(a) True
(b) False
2. When determining a company’s fair value, multiples should be utilised in isolation
without considering other financial measures.
(a) True
(b) False
3. Multiples in finance are used to:
(a) Determine the company’s absolute value.
(b) Examine the various firms’ respective valuations.
(c) Determine a company’s net profit margin.
(d) Assess a company’s risk profile.
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4. Which of the following is NOT a commonly used financial multiple in relative NOTES
valuation?
(a) Price-to-Earnings (P/E) ratio.
(b) Price-to-Book (P/B) ratio.
(c) Price-to-Sales (P/S) ratio.
(d) Gross Margin ratio.
5. Multiples are frequently employed in relative valuation to ascertain a company’s
market value relative to its peers in the industry, making them an important tool for
assessing a company’s __________________.

13.5 PRICE EARNING MULTIPLES

An effective approach to conceptualise the worth of an asset is by seeing it as a multiple
of the earnings it produces. For example, when buying a share in a corporation, the price
is typically calculated as a percentage of the earnings per share generated by the business.
By using the current earnings per share, one may calculate the current PE, or price/
earnings ratio. Alternatively, the trailing PE can be computed by taking the earnings for
the previous four quarters. Finally, the forward PE can be estimated using the anticipated
profits per share for the upcoming year.
A useful metric for determining how pricey a stock is right now compared to its earnings
per share is the earnings multiple. A historically high price-to-earnings ratio indicates that
a stock is likely overpriced and may not be a good investment at this time because of its
high price. Furthermore, comparing comparable organisations’ earnings multipliers can
help illustrate how expensive the stock prices of other companies are in relation to one
another. Below is a discussion of some of the most significant Earnings Multiples.

13.5.1 PRICE TO EARNINGS (PE)

One often used statistic in financial research to evaluate the valuation of a company’s
shares is the Price-to-Earnings (P/E) ratio. It illustrates the connection between the stock
price and EPS (earnings per share) of the business. The P/E ratio may be computed using
the formula:
Price Per Share
P/ E =
Earnings Per Share

A higher P/E ratio generally indicates that investors are willing to pay more for each unit of
earnings, suggesting that the stock may be overvalued. Conversely, a lower P/E ratio may
suggest that the stock is undervalued.
Let’s consider an example to illustrate how the P/E ratio is used to assess valuation:
Suppose Company ABC has a stock price of Rs. 50 per share and earnings per share (EPS)
of Rs. 5. The P/E ratio would be calculated as follows:
50
P/=
E = 10
5
329
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Relative Valuation
NOTES This means that investors are willing to pay Rs. 10 for every rupee of earnings generated
by Company ABC.
Let’s now assess this P/E ratio in relation to other firms within the same industry. Company
ABC’s P/E ratio of 10 may suggest that its stock is cheap in comparison to its peers if the
industry average P/E ratio for similar businesses is 15. This might be seen by investors as
a chance to purchase the company at a discount before its price comes up to the industry
average.
Conversely, in the event if Company ABC’s P/E ratio exceeded the industry average by 20,
this may indicate that the stock is overpriced. This might be interpreted by investors as a
hint to sell the stock or hold off on buying it until its valuation drops.
In conclusion, the P/E ratio helps investors make well-informed decisions regarding the
purchase, sale, or ownership of stocks by offering insightful information about a company’s
valuation in relation to its profits.
The predominant Earnings multiple used by analysts is the price-to-earnings ratio
(PE ratio), which is the quotient of the market price of the stock divided by the earnings
per share produced by the firm.
PE ratio = Market price per common share/Earnings per share
Market Price per common share: is generally the present share price.
is sometimes the average price for the year.
Earnings Per Share (EPS): EPS in most recent financial year
EPS per share in trailing 12 months (Trailing PE)
Projected earnings per share next year (Forward PE)
Projected earnings per share in Future year
The price-to-earnings (PE) ratio represents the amount of money paid by investors for
each unit of earnings. For instance, a price-to-earnings ratio (PE ratio) of 10x signifies
that shareholders are valuing the company at Rs. 10 for each Rs. 1 of profits generated
per share. The price-to-earnings (PE) ratios of firms and sectors may differ significantly
due to variables such as risk, growth potential, and other relevant considerations. It is
also vital to clarify whether the PE ratio is computed on a forward or historical basis.
A historical price-to-earnings ratio (PE) evaluates the profits from the previous period in
relation to the current market price, while a forward PE assesses the projected earnings
for the upcoming period in relation to the present price. Despite of having many above
stated benefits, PE ratio has the following limitations.
Firstly, Forward P/E ratios are based on analysts’ forecasts of a company’s future earnings,
which are subject to various factors such as economic conditions, industry trends, and
company-specific developments. If these earnings estimates turn out to be inaccurate or
overly optimistic, the forward P/E ratio may not accurately reflect the true valuation of
the company’s stock. Therefore, investors should exercise caution and consider multiple
factors when relying on forward P/E ratios for investment decisions.
Furthermore, the P/E ratio may be susceptible to the impact of accounting practises
and exceptional occurrences, which can potentially skew its precision as a measure of
valuation. Furthermore, it fails to consider other crucial variables such as a company’s
financial obligations, the dynamics of the sector it operates in, or its competitive
330 standing.
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In conclusion, the P/E ratio is a useful tool for determining a company’s value, but it should NOTES
only be used in conjunction with other financial indicators and a thorough analysis of the
business’s prospects for growth and financial stability. When making financial decisions,
it is essential to thoroughly consider the advantages and disadvantages of the P/E ratio.
Example: Assume that Company A and Company B, two renowned businesses that are
both involved in the technology industry. The current stock price, EPS of the companies
based on historical basis are as follows.

Company Current Stock Price Earnings Per Share (Eps) P/E Ratio =
Stock Price/EPS
A 1000 50 1000/50 = 20
B 2000 100 2000/100 = 20

In this example, both companies have a P/E ratio of 20. This means that for every
Rs. 1 of earnings per share, investors are willing to pay Rs. 20. However, it’s essential
to understand that even though both companies have the same P/E ratio, it doesn’t
necessarily mean they are identical in terms of risk or growth prospects. Other factors,
like the company’s growth potential, industry conditions, and competitive position, need
to be considered when making investment decisions. For example, Analysts anticipate
that Company A’s EPS for the coming year will be 70, resulting in a 1 year forward P/E
ratio of 1000/70 = 14x. As a result, if earnings are predicted to rise, the forward PE
will be lower than the historical PE. Forward earnings are usually more interesting, but
they are more subjective than historical earnings because they depend on the analyst’s
predictions of future growth.

13.5.2 PRICE EARNINGS GROWTH (PEG)

An investor can assess a company’s prospective worth by utilising the Price-Earnings
Growth (PEG) ratio. In addition to the price-to-earnings (PE) ratio, it considers the expected
earnings growth rate of a business. While the PE ratio measures how much an investor is
willing to pay for each rupee that a firm makes, the PEG ratio takes growth into account.
PEG Ratio = PE Ratio/Earnings Growth Rate
The Earnings Growth Rate refers to the anticipated yearly increase in a company’s profits.
The basis for it might be derived from past growth patterns, analyst projections, or other
sources. A greater growth rate signifies that the organisation is projected to augment its
profits at an accelerated rate.
Typically, when the PEG ratio is below 1, it indicates that the stock could be undervalued.
This is because the market is not fully considering the company’s potential for profits
growth. When a company’s PEG ratio is 1, it means that its valuation is fair given its rate
of earnings growth. A PEG ratio greater than one may indicate that the stock is overpriced
since it implies that investors may be willing to pay more for the company’s anticipated
earnings gain.
It is imperative to recognise the inherent limits of the PEG ratio. For example, it is
dependent upon estimates of future profit growth, which are subject to change and
uncertainty. Additionally, because various companies may have varying risk profiles and
331
growth forecasts, the PEG ratio is particularly helpful for evaluating equities within the
UNIT 13
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NOTES same sector or industry. To make wise investing decisions, investors should use the PEG
ratio in addition to other financial indicators and data.
Example: Suppose you are considering investing in Company ABC, and you want to
evaluate its stock using the PEG ratio. Here’s the information you have:
Current stock price of Company ABC: `100 per share
Earnings per share (EPS) for the last year: `4 per share
Estimated annual earnings growth rate for Company ABC: 10%
The P/E Ratio = `100/`4 = `25
The PEG Ratio = 25/10 = 2.5
In this example, the PEG ratio for Company ABC is 2.5. The PEG ratio indicates that the
stock is trading at 2.5 times its expected earnings growth rate. This indicates an overpriced
stock given its earnings growth rate.

CHECK YOUR PROGRESS – IV

1. What is a company’s price-to-earnings (P/E) ratio if its EPS is `2 and its stock is
trading at `20 per share?
(a) 10 (b) 2
(c) 0.2 (d) 40
2. What does a company’s stock often indicate when its P/E ratio is high?
(a) Undervaluation
(b) Overvaluation
(c) Stable growth
(d) No meaningful information
3. One measure of valuation is the PEG ratio that takes into account a company’s
____________ and ___________ when assessing its stock’s potential for growth.
4. A PEG ratio of 1 is often considered as an indicator that a stock may be fairly
valued, while a PEG ratio below 1 may suggest that the stock is ____________ and
potentially undervalued, and A PEG ratio greater than 1 could indicate that the
stock is ____________.
5. An overvalued stock is invariably indicated by a high P/E ratio.

13.6 BOOK VALUE MULTIPLES

Investors often use the correlation analysis to determine if a company is overvalued or
undervalued based on the relationship between the purchase price and book value of
equity, also known as net worth. The resulting price/book value ratio can differ significantly
across industries, based on the growth potential and investment quality of each industry.
Price-to-book (PB) multiples, also known as book value multiples, are financial metrics
that are used to evaluate a company’s value in proportion to its accounting/book value.
332
The book value of a firm is effectively its net asset value, computed by subtracting the
total liabilities from the total assets on its balance sheet. However Intangible assets, like
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patents, trademarks, copyrights, goodwill, and intellectual property, are excluded from NOTES
the calculation of book value. Investors can use book value multiples to assess if the stock
of a firm is overvalued or undervalued in relation to this measure.
The price-to-book value ratio is the prevalent book value multiple that is frequently
employed (PB ratio). Two more notable book value multiples are Value/Book Value of
Assets and Value/Replacement Cost (Tobin’s Q).
Value/Book Value of Assets:
• This multiple compares the market value of a company’s total assets to its book
value of assets.
• It indicates how the market values the company’s assets relative to their reported
accounting value.
• A ratio greater than 1 suggests that the market values the company’s assets higher
than their book value, which may indicate investor confidence in the company’s
asset quality and growth prospects.
• Conversely, a ratio less than 1 may suggest that the market values the company’s
assets lower than their book value, which could indicate concerns about asset
quality or future performance.

Value/Replacement Cost (Tobin’s Q):

• Tobin’s Q compares the market value of a company to the replacement cost of
its assets.
• It is calculated by dividing the market value of the company (market capitalization)
by the replacement cost of its assets.
• A ratio greater than 1 implies that the market values the company higher than the
cost of replacing its assets, indicating potential overvaluation.
• On the other hand, a ratio less than 1 suggests that the market values the company
lower than the cost of replacing its assets, indicating potential undervaluation.
• Tobin’s Q is often used to assess the efficiency of capital investment and to gauge
whether a company is investing its resources wisely.

These book value multiples provide insights into how the market perceives the value of a
company’s assets relative to their reported or replacement costs, which can help investors
assess the company’s financial health and investment potential.

13.6.1 PRICE TO BOOK (PB) VALUE

A financial ratio called price to book value (P/B) is used in relative valuation to determine
how valuable a company’s shares are in relation to one another by contrasting their market
prices (the current share price) and book values (the net asset value of the company).
This ratio is also sometimes referred to as the price-to-equity ratio because it relates the
market price to the shareholders’ equity on the company’s balance sheet.
The following formula can be used to get the P/B ratio:
P/B Ratio = Market Price per Share/Book Value per Share
Here, Book Value per Share refers to the net asset value of the company, which is essentially
the difference between its total assets and total liabilities. To calculate book value per 333
share, you divide the total book value by the number of outstanding shares.
UNIT 13
Relative Valuation
NOTES The PB ratio offers insights into the market’s valuation of a company’s equity relative to
its declared assets and liabilities on the balance sheet. It helps analysts and investors
determine if a firm is overpriced or undervalued in relation to its book value. A low price-
to-book (PB) ratio may imply that the company is underpriced, while a high PB ratio may
signal overvaluation. The PB ratio is especially valuable for evaluating firms operating in
asset-intensive sectors, such as banking, manufacturing, and real estate. Within certain
sectors, the book value might serve as a more dependable measure of the company’s
worth due to the substantial impact of its assets on revenue generation. Nevertheless,
the PB ratio does possess some constraints. For organisations that own a substantial
quantity of intangible assets, such as technology companies, the price-to-book (PB) ratio
may not provide a precise depiction of their actual worth, as it fails to include these
intangible assets.
Example 1: Suppose there are two well-known companies A and B operating in the
automobile sector. You got the following information from their company’s balance
sheets. For both companies the number of outstanding shares is 100.

Company Current Total Total Book Value = Total Price/Book

Stock Price assets Liabilities Assets-Liabilities/ Value
Outstanding shares
A `50 `10,000 9000 10 50/10 = 5
B `60 `20,000 `16000 40 60/40 = 1.5

Company A’s P/B ratio is 5, which means the market is valuing its assets at 5 times their
book value. Whereas, Company B’s P/B ratio is 1.5, indicating that the market is valuing its
assets at 1.5 times their book value.
If the industry average P/BV ratio is 3 then Company A seems to be overpriced while
opposite is the case with company B.
In general, a lower P/B ratio indicates that a stock can be cheap. But it’s also important
to consider other aspects, such as industry’s average PB ratio, the company’s growth
potential, and its general financial health, among others.
Example 2: As per the Balance Sheet of MRF Limited as of 31 March 2021, the following
data is collected to calculate the Book Value.
Total Assets: 22,581 cr.
Total Liabilities: 8,979 cr.
Intangible Assets: 24 cr
Book Value of MRF Ltd can be calculated as (22,581 – 24 – 8,979) = 13,578 cr.
Book value per share can be calculated by dividing the value with number of shares.
Number of outstanding shares: 42,42,143 shares
Book value per share: 13,578/0.42 = Rs. 32328.57
Stock price of MRF Ltd. = Rs. 71,328
P/B Ratio = 2.21x

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Source: https://www.etmoney.com/blog/how-p-b-ratio-can-help-you-in-stock-selection/
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Example to calculate fair price with P/BV multiple NOTES
Company XYZ has a book value per share of Rs. 50 and the industry average P/BV multiple
is 2.5x. To calculate the fair price of Company XYZ’s stock:
Fair Price = Book Value per Share × P/BV Multiple
Substituting the values:
Fair Price = Rs. 50 × 2.5 = INR 125 per share
Therefore, based on the P/BV multiple valuation method, the fair price of Company XYZ’s
stock is Rs. 125 per share. This suggests that, according to the market’s assessment, each
share of Company XYZ is worth Rs. 125 based on its book value and the industry average
P/BV multiple.

CHECK YOUR PROGRESS – V

1. The computation of the book value per share involves deducting the total liabilities
from the total assets and dividing the result by the entire number of outstanding
shares.
(a) True
(b) False
2. A company’s stock is trading below book value if its price-to-book (P/B) ratio is less
than 1.
(a) True
(b) False
3. The stock price of a corporation is compared to its:
(a) Earnings per share (EPS)
(b) Market capitalization
(c) Book value per share
(d) Dividend yield
4. What does a stock of a firm usually indicate if its P/B ratio is less than 1?
(a) Overvaluation
(b) Undervaluation
(c) Stable growth
(d) No meaningful information

13.7 ENTERPRISE VALUE MULTIPLE

The Enterprise Value (EV) multiple is a financial measure used in relative valuation, a
technique for valuing a firm by comparing it to other comparable companies within the
same industry. Investors and analysts use the EV multiple as a tool to assess a company’s
relative value. It does this by comparing the firm’s enterprise value to a certain financial 335
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NOTES measure, such as profits, sales, or EBITDA (earnings Before Interest, Taxes, Depreciation,
and Amortisation).
Enterprise Value (EV) is a comprehensive metric that assesses the whole worth of a firm.
It considers the value of all of its outstanding shares, or market capitalization, in addition
to its debt, preferred stock, and minority interest in other businesses. Essentially, EV
represents the whole cost of acquiring the complete organisation, including its debt and
other financial liabilities. It is a comprehensive measure of a company’s total capitalization
and is calculated as follows:

Enterprise Value (EV) = M

 arket Capitalization + Total Debt + Minority Interests
+ Preferred Shares − Cash and Cash Equivalents

The most prominent Enterprise Value (EV) Multiples include EV/EBITDA, EV/EBIT and EV/Sales.

13.7.1 ENTERPRISE VALUE TO EBITDA MULTIPLE

The Enterprise Value to EBITDA (EV/EBITDA) multiple is a financial metric used especially
when evaluating the acquisition of a company or comparing the relative value of different
companies. It is calculated by dividing a company’s enterprise value by its Earnings Before
Interest, Taxes, Depreciation, and Amortization (EBITDA).

EV/EBITDA = Enterprise Value/EBITDA

EBITDA = Net profit + Interest + Tax + Depreciation + Amortisation

A company’s valuation in relation to its earnings is evaluated using the EV/EBITDA multiple.
An organisation may be undervalued if its multiple is lower; on the other hand, it may be
overvalued if its multiple is higher. It’s essential to compare EV/EBITDA multiples across similar
companies or industries to make meaningful conclusions about a company’s valuation.
The EV to EBITDA Multiple is particularly useful in merger and acquisition (M&A) analysis
because it gives a more thorough view of a organization’s value, accounting for its debt
and operational performance without the distortions introduced by taxes, interest, and
non-cash expenses like depreciation and amortization.
Example: Let’s say you are analyzing two companies, Hindustan Unilever Limited (HUL)
and Indian Tobacco Company Limited (ITC), both of which operate in the same industry
(e.g., the Fast-moving consumer goods sector) and have similar business profiles. You
want to determine which of these companies is a more attractive investment option.
Enterprise Value of HUL ltd (Market Capitalization + Total Debt − Cash & Cash Equivalents) =
₹5,949 billion
Enterprise Value of Company ITC Ltd. = ₹4,610.8 billion
EBITDA of HUL Ltd. = ₹136.32 billion
EBITDA of ITC Ltd. = ₹287.61 billion
For Company A, EV/EBITDA = 5,949/136.32 = 43.63x
For Company B, EV/EBITDA = 4,610.8/287.61 = 16.03x
If the average multiple of nearest peers is 20 times, then a lower EV/EBITDA multiple
336 (ITC Ltd. in this case) typically suggests that the company is trading at a lower valuation
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relative to its EBITDA, which may indicate that it’s undervalued or more attractively priced NOTES
compared to HUL Ltd. On the other hand, A higher EV/EBITDA multiple (HUL Ltd. in this
case) suggests that the company is trading at a higher valuation relative to its EBITDA.
Example to Calculate Fair Value
Company ABC has an enterprise value of Rs. 100 crores and an EBITDA (earnings
before interest, taxes, depreciation, and amortization) of Rs. 20 crores. To calculate the
enterprise value-to-EBITDA (EV/EBITDA) multiple, we divide the enterprise value by the
EBITDA:
EV/EBITDA = Enterprise Value/EBITDA
Using the numbers provided:
EV/EBITDA = Rs. 100 crores/Rs. 20 crores
EV/EBITDA = 5
So, Company ABC has an EV/EBITDA multiple of 5.
Now, let’s interpret this multiple. A multiple of 5 means that the market values Company
ABC’s total enterprise value at 5 times its EBITDA. In other words, investors are willing to
pay Rs. 5 for every Rs. 1 of EBITDA generated by Company ABC.
To assess fair value through the EV/EBITDA multiple, we can compare Company ABC’s
multiple to those of its industry peers or to historical multiples of the company itself. If
the average EV/EBITDA multiple for similar companies in the industry is 6, and Company
ABC’s multiple is 5, it may indicate that Company ABC is undervalued relative to its peers.
Conversely, if Company ABC’s multiple is higher than the industry average, it may suggest
that the company is overvalued.

13.7.2 ENTERPRISE VALUE TO REVENUE MULTIPLE

The Enterprise Value to Revenue Multiple, commonly known as EV/Revenue or EV/Sales
Multiple. It compares the total value of a firm to its total sales revenue. The calculation
involves dividing a company’s enterprise value (EV) by its total sales.
EV/REVENUE = Enterprise Value/Total Revenue
The multiple reveals how the market perceives a company’s revenue-generating capacity
in proportion to its overall enterprise value. It is frequently used when comparing
companies in the same industry or area. Generally good EV/Sales multiples are between
1x and 3x. A lower EV/Sales ratio suggests that the business’s valuation may be lower than
its sales. This could suggest that the company is an attractive investment opportunity.
A higher EV/Sales ratio suggests that the company may be overvalued relative to its sales.
This may be a signal to investigate further to see if the valuation is justified.
It is significant to remember that the optimal EV/Sales ratio varies by industry and is
dependent on a number of variables, including growth projections and market conditions.
So, this multiple should be used as part of a comprehensive analysis rather than as the
sole determinant of an investment decision.
Example 1: Suppose we have three technology companies, Company A, B and C, and
you want to determine which one is relatively undervalued or overvalued based on their
EV/Revenue multiples. You got the following information from the company’s annual
financial statements (Values in Rs. Million). 337
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Relative Valuation
NOTES Company Enterprise Value (EV) Annual Revenue EV/Revenue multiple
A Rs. 20 Rs. 5 20/5 = 4x
B Rs. 30 Rs. 10 30/10 = 3x
C Rs. 50 Rs. 10 50/10 = 5x

In this example, Company A is trading at an EV/Revenue multiple of 4x, which means

investors are willing to pay Rs. 4 for every Re. 1 of annual revenue generated by the company.
Company B, on the other hand, has an EV/Revenue multiple of 3x. Investors are prepared
to spend Rs. 3 for each Re. 1 in yearly income. And In case of company C investors are paying
more than A & B i.e Rs. 5 every Re. 1 of annual revenue. This suggests that Company B may
be relatively undervalued compared to A & C based on this multiple.
Example 2: In this Example, we have compared the EV/Revenue multiple of three
companies TCS Ltd, HCL Technologies Ltd and Infosys Ltd.

Company Enterprise Value (EV) Annual Revenue EV/Revenue multiple

TCS Rs. 147,442.21 Rs. 8301.92 17.76x
HCL TECH Rs. 41,233.00 Rs. 3114.27 13.24x
Infosys Rs. 69,133.43 Rs. 4608.86 15.00x

We can observe that the EV/Revenue ratio of HCL tech is comparatively low, indicating
that it may be undervalued and worth considering for investors. However, TCS ltd has a
comparatively high EV/revue multiple of 17.76x compared to the other companies being
studied.
Example to assess Fair Value
XYZ Ltd has an enterprise value of Rs. 200 crores and total revenue of Rs. 50 crores.
To calculate the enterprise value-to-revenue (EV/Revenue) multiple, we divide the
enterprise value by the total revenue:
EV/Revenue = Enterprise Value/Total Revenue
Using the numbers provided:
EV/Revenue = Rs. 200 crores/Rs. 50 crores
EV/Revenue = 4
So, XYZ Ltd has an EV/Revenue multiple of 4.
Now, let’s interpret this multiple. A multiple of 4 means that the market values XYZ Ltd’s
total enterprise value at 4 times its total revenue. In other words, investors are willing to
pay Rs. 4 for every Rs. 1 of revenue generated by XYZ Ltd.
To assess fair value through the EV/Revenue multiple, we can compare XYZ Ltd’s multiple
to those of its industry peers or to historical multiples of the company itself. If the
average EV/Revenue multiple for similar companies in the industry is 5, and XYZ Ltd’s
multiple is 4, it may indicate that XYZ Ltd is undervalued relative to its peers. Conversely,
if XYZ Ltd’s multiple is higher than the industry average, it may suggest that the company
is overvalued.
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CHECK YOUR PROGRESS – VI NOTES
1. A company with an Enterprise Value to Revenue Multiple of 3x means that:
(a) Investors are willing to pay `3 for every `1 of the company’s revenue.
(b) The company is undervalued.
(c) The company’s revenue is declining.
(d) The company is not generating any revenue.
2. Enterprise Value includes a company’s market capitalization, plus its debt, minus its
______________
3. A corporation is more expensive in relation to its EBITDA if its EV/EBITDA multiple is
lower.
(a) True
(b) False
4. A company with an EV/EBITDA multiple of 10x is said to be trading at:
(a) A discount
(b) Fair value
(c) A premium
(d) Impossible to determine without more information
5. A negative EBITDA value can result in a meaningful EV/EBITDA multiple.
(a) True
(b) False

13.8 SECTOR SPECIFIC MULTIPLES

Now Let us understand Sector specific multiples. Sector-specific multiples, also known as
industry-specific multiples or financial ratios, are used in financial analysis to assess the
valuation and performance of companies within a particular industry or sector.
These multiples help investors, analysts, and stakeholders compare companies within the
same sector, as they take into account the unique characteristics and financial dynamics
of that sector.
Example: Enterprise Value per Subscriber (EV/Subscriber) is used in the same industries
to evaluate the value of a company per subscriber or customer. Used in the same
industries to evaluate the value of a company per subscriber or customer. Subscriber
here refers to the total number of customers or subscribers that a company serves.
Ex: Bharati Airtel Ltd.
In the same manner, EV/Bed (Enterprise Value per Bed) multiple used in the context of
evaluating companies that provide services such as cable TV, internet, or phone services
to customers. Bed refers to the number of subscriber connections, which could represent
customers or households.

339
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NOTES CHECK YOUR PROGRESS – VII
1. Enterprise value multiples are used to assess the total value of a company, including
both equity and debt.
(a) True
(b) False
2. In the retail industry, which of the following multiples is used to assess a company’s
efficiency in managing its inventory?
(a) Price to Earnings (P/E) ratio
(b) Price to Sales (P/S) ratio
(c) Inventory Turnover ratio
(d) Debt to Equity (D/E) ratio
3. Which of the following is a commonly used multiple for valuing companies in the
technology sector?
(a) Price to Earnings (P/E) ratio
(b) Price to Sales (P/S) ratio
(c) Price to Book (P/B) ratio
(d) Price to Earnings Growth (PEG) ratio
4. Sector specific multiples are useful for ____________.
5. Which of the following multiples is commonly employed in the automotive sector
to assess a company’s market worth in relation to its earnings?
(a) Price to Sales (P/S) ratio
(b) Price to Book (P/B) ratio
(c) Price to Earnings (P/E) ratio
(d) Price to Cash Flow (P/CF) ratio

13.9 ADVANTAGES OF RELATIVE VALUATION

To ascertain a company’s value in relation to similar companies, analysts and investors
commonly employ relative valuation in finance and investment analysis. It provides a
number of advantages that make it a useful instrument for comparing the value of assets
such as stocks, bonds, and companies. Some of the key advantages of relative valuation
include:
• Straightforward: Relative valuation is relatively straightforward, quick and simple
to Comprehend, making it available to a broad spectrum of investors and analysts.
It includes comparing the asset’s value to that of other assets in the same sector
or industry.
• Comparative Simplicity: It enables direct asset comparisons, making it advantageous
when rating and selecting investments. Analysts can quickly discover assets that are
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cheap or overvalued in comparison to their counterparts.
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• Industry-specific: Relative valuation considers industry-specific criteria, which are NOTES
essential for evaluating companies or assets within a specific sector with distinctive
attributes.
• Wide Use: Relative valuation can be used for many types of assets, such as
businesses, stocks, bonds, and real estate. One can use it for many things, like
picking stocks, managing wealth, and analysing mergers and acquisitions.
• Market-based: Relative valuation is market-driven, relying on current market
prices and data. This reflects the collective wisdom of investors and is often more
up-to-date than other valuation methods.
• Transparency: Relative valuation is frequently regarded as more transparent than
other valuation methodologies because to its reliance on observable market data,
as opposed to subjective assumptions.

In addition to the advantages listed above, relative valuation is frequently combined with
other valuation techniques, such as discounted cash flow (DCF) analysis, to provide a
more comprehensive view of an asset’s value.

13.10 DISADVANTAGES OF RELATIVE VALUATION

Despite its broad applicability and benefits, it is critical to recognise that relative valuation
has following mentioned limitations.
• As the quality of the valuation is highly dependent on identifying suitable
comparable companies. In some industries, it can be difficult to find genuinely
comparable companies, which can lead to inaccurate valuations.
• Relative valuation is highly dependent on market prices, which are susceptible
to short-term market sentiment and fluctuations. As a consequence, it may not
accurately reflect the company’s intrinsic value.
• Certain industries may be more susceptible to specific market and economic
conditions, which can reduce the reliability of relative valuations. Cyclical industries,
for instance, can have volatile earnings, rendering comparisons less meaningful.
• Relative valuation is based on historical data and does not explicitly consider future
growth prospects or changes in the industry landscape, which can be a significant
limitation, especially when valuing high-growth companies.
• The selection of comparable companies, as well as the choice of valuation multiples
(e.g., PE, EV to EBITDA), can be subjective. Different analysts may choose different
peers or multiples, leading to different valuations for the same company.
• It assumes that the market has put the right value on the company. When market
prices are very different from their actual worth, like during bubbles or crashes,
relative valuation can be very inaccurate.

13.11 LET US SUM UP

Relative valuation methods involve comparing a company’s stock price or enterprise value
to key financial metrics like earnings, book value, or EBITDA. Investors and analysts can
evaluate a company’s valuation by considering its industry and market conditions with
the aid of these multiples. Every multiple has advantages and disadvantages, and in order
to obtain a more complete picture of a company’s value, a thorough valuation analysis 341
usually takes into account a number of criteria.
UNIT 13
Relative Valuation
NOTES The focus of relative valuation is on different approaches to value a business by
contrasting it with other comparable businesses in the industry. Enterprise value
multiples, book value multiples, and earnings multiples are the three main strategies
that are covered.
A company’s stock price and its “Earnings Per Share” are compared using earnings multiples,
such as the Price-to-Earnings (P/E) ratio (EPS). One popular measure for evaluating a
company’s valuation in relation to its earnings is the P/E ratio. A higher P/E ratio typically
implies a higher valuation, but it may also indicate higher growth expectations or market
sentiment.
Book value multiples compare a company’s stock price to its book value per share. The
Price-to-Book (P/B) ratio is a common multiple of book value. The P/B ratio evaluates a
company’s market valuation in relation to its net assets. A reduced P/B ratio can indicate
low growth potential or an undervalued company.
Enterprise value multiples, such as the “Enterprise Value-to-EBITDA” (EV/EBITDA) ratio,
consider the entire enterprise’s value, including debt and equity.
When evaluating a company’s overall valuation, accounting for its capital structure,
EV/EBITDA is frequently utilised. A smaller ratio can point to a more appealing
valuation, but it’s crucial to take industry standards and company-specific elements
into account. When evaluating a company’s overall valuation, accounting for its
capital structure, EV/EBITDA is frequently utilised. A smaller ratio can point to a more
appealing valuation, but it’s crucial to take industry standards and company-specific
elements into account.

13.12 KEYWORDS
Relative Valuation: The process of valuing an asset by contrast it with other assets
that are similar to it is known as relative valuation. It’s also known as comparable
valuation.
Valuation Multiples: A financial statistic known as a valuation multiple, or simply
“multiple,” is used to compare an asset’s or company’s fair worth to another financial
indicator.
Price-to-Earnings: PE Multiple is computed by dividing a company’s market price per
share by its “Earnings per share” (EPS). The amount that investors are willing to pay for
every dollar of earnings is shown by this multiple.
Book Value: Book value is a financial indicator that illustrates the intrinsic value of a
company’s assets based on its balance sheet. It is often referred to as “net asset value”
or “carrying value.” It is calculated by subtracting the entire liabilities of an organisation
from its total assets.
Price-to-Book Value: PB Multiple is by dividing the current market price per share of a
organization’s share by its book value per share. It provides insight into whether a stock is
overpriced or underpriced in relation to its book value.
Enterprise Value: A financial metric called enterprise value (EV) is used to assess a company’s
total value by considering both its debt and ownership components. A company’s market
342
capitalization, total debt, minority interest, and preferred shares are added to its total
worth, which is then subtracted from its cash and cash equivalents.
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Financial Analysis and
Business Valuation
13.13 REFERENCES AND SUGGESTED ADDITIONAL READING NOTES
REFERENCES
1. Vaidya. (n.d.). Comparable Company Analysis. https://www.wallstreetmojo.com/.
2. https://www.etmoney.com/blog/how-p-b-ratio-can-help-you-in-stock-selection/

SUGGESTED ADDITONAL READINGS

1. Damodaran, A. (2016). Damodaran on valuation: security analysis for investment
and corporate finance. John Wiley & Sons.
2. Damodaran, A. (2012). Investment valuation: Tools and techniques for determining
the value of any asset (Vol. 666). John Wiley & Sons.
3. Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: measuring and managing
the value of companies (Vol. 499). john Wiley and sons.

13.14 SELF-ASSESSMENT QUESTIONS

1. In relative valuation, what is the primary goal when comparing a company to its peers?
(a) To determine the company’s intrinsic value.
(b) To identify potential growth opportunities.
(c) To assess the company’s market price relative to its peers.
(d) To calculate the company’s net profit margin.
2. Which of the following is NOT a limitation of relative valuation?
(a) It depends on the accuracy of market prices.
(b) It may not account for differences in growth rates.
(c) It does not consider a company’s historical performance.
(d) It may not account for differences in risk.
3. When conducting relative valuation, which of the following is NOT a key
consideration?
(a) Economic and industry factors.
(b) The company’s historical financial performance.
(c) The company’s management team.
(d) Market sentiment and investor behaviour.
4. If a company’s Price-to-Book (P/B) ratio is less than 1, it typically suggests:
(a) The company is financially healthy.
(b) The company is undervalued relative to its book value.
(c) The company is highly leveraged.
(d) The company has strong earnings growth.
343
UNIT 13
Relative Valuation
NOTES 5. The Enterprise Value-to-EBITDA (EV/EBITDA) ratio is used to:
(a) Evaluate a company’s liquidity.
(b) Measure a company’s ability to generate operating income.
(c) Assess a company’s profitability.
(d) Estimate a company’s future growth potential.
6. What does a low Price-to-Sales (P/S) ratio suggest in relative valuation?
(a) The company is undervalued compared to its peers.
(b) The company is overvalued compared to its peers.
(c) The company is not generating revenue.
(d) The company has high profit margins.
7. Which of the following ratios is commonly used in relative valuation for publicly
traded companies?
(a) Price-to-Earnings (P/E) ratio.
(b) Return on Investment (ROI).
(c) Net Present Value (NPV).
(d) Debt-to-Equity (D/E) ratio.
8. What is relative valuation in finance?
(a) Valuing an asset based on its intrinsic characteristics.
(b) Valuing an asset based on its current market price compared to similar assets.
(c) Valuing an asset based on its historical performance.
(d) Valuing an asset based on its future cash flows.
9. Which of the following is an advantage of relative valuation methods?
(a) They are not dependent on market data
(b) They provide an absolute value for a company
(c) They consider a company’s future growth potential
(d) They are easy to understand and calculate
10. When conducting a relative valuation, which of the following is NOT typically
considered when comparing companies?
(a) Market capitalization
(b) Revenue
(c) Dividend history
(d) Earnings

344
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Financial Analysis and
Business Valuation
13.15 CHECK YOUR PROGRESS – POSSIBLE ANSWERS NOTES
Check Your Progress – I
1. undervalued, overvalued
2. Comparable
3. (c)
4. False
5. True
Check Your Progress – II
1. False
2. True
3. Identify a peer group
4. operating characteristics
5. True
Check Your Progress – III
1. True
2. False
3. (b)
4. (d)
5. Valuation
Check Your Progress – IV
1. (a)
2. (b)
3. P/E (Price-to-Earnings) ratio, expected earnings growth rate
4. undervalued, overvalued
5. False
Check Your Progress – V
1. True
2. True
3. (c)
4. (b)
Check Your Progress – VI
1. (a)
2. Cash 345
UNIT 13
Relative Valuation
NOTES 3. False
4. (d)
5. True
Check Your Progress – VII
1. True
2. (c)
3. (b)
4. comparing and valuing companies within the same industry or sector.
5. (c)

13.16 ANSWERS TO SELF-ASSESSMENT QUESTIONS

1. (c) 2. (c) 3. (c) 4. (b) 5. (b)
6. (a) 7. (a) 8. (b) 9. (d) 10. (c)

346
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