Chapter 10: Valuation Principles

Chapter 10: Valuation Principles – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book 

Difference Between Price and Value in Investing

Definition Distinction:

  • Price: Set by market dynamics, particularly the most panicked seller.
  • Value: Determined by underlying assets and cash flows, not directly reflected in market price.

Investing Challenge and Opportunity:

  • Goal: Identify significant differences between an asset’s market price and its intrinsic value.
  • Approach: Avoid extreme market emotions and make independent judgements..

Warren Buffett’s Perspective:

  • Quote: “Price is what you pay;value is what you get.”
  • Emphasises the distinction between market cost (price) and actual worth (value).

Price vs. Value in Stock Market:

  • Price: Easily available, known publicly from the stock market.
  • Value: Subjective, based on individual analysis and evaluation at a specific time.

Valuation Process:

  • Involves uncertainty due to variable inputs.
  • Output: Considered an educated estimate, not precise.
  • Requires diligence in valuing the asset.

Valuation as an Art and Science:

  • Combines knowledge and experience.
  • Involves professional judgement for fair asset valuation.

Key Takeaway:

  • Understanding the divergence between price and value is crucial for successful investing.
  • Requires both analytical skills and emotional discipline.

Why Valuations Are Required?

Purpose Variability:

  • Valuation objectives differ based on individual or organisational needs.

Common Reasons for Valuation:

  1. Investment Decisions: Buying or selling a business.
  2. Mergers and Acquisitions: Assessing value during corporate restructuring.
  3. Owner Analysis: Understanding the business’s value to its owners.
  4. Equity Considerations: Ensuring fair treatment of stakeholders in equity swaps.
  5. Regulatory Compliance: Fulfilling accounting, taxation, and legal requirements.

Valuation Goal:

  • Main objective is to determine if an asset is fairly priced, over-priced, or under-priced.
  • Connects market price with intrinsic value.

Valuation Process Limitations:

  • Inherent uncertainties due to variable inputs.
  • Valuers often present multiple scenarios to account for these uncertainties.
  • Scenarios reflect changes in primary variables and their impact on valuation.

Key Takeaway:

  • Valuations are essential in various business contexts for informed decision-making.
  • Involves understanding and interpreting the relationship between price and value.

Sources of Value in a Business – Earnings and Assets

Buffett’s Principle:

  • Two main sources of value in a business: Earnings and Assets.

Cash Flow Streams:

  • Assets generate two types of cash flows: periodic earnings and a final inflow from the sale.
  • Examples:
    • Bonds: Coupon earnings and one-time cash flow from redemption/sale.
    • Equities: Dividend earnings and cash flow from sale.
    • Real Estate: Rental income and capital appreciation on sale.

Business Purpose:

  • Established to create earnings and the potential for cash flow from asset sales.
  • Liquidation as an option if earnings decrease or cease.

Lender’s Perspective:

  • Primary focus: Business’s ability to generate cash flows to meet obligations.
  • Collateral: Secondary, a fallback for loan recovery if cash flow estimates fail.

Asset Valuation vs. Liabilities:

  • Business assets’ ability to cover all liabilities and equity settlements is uncertain.
  • Assets might be valued lower than their balance sheet appearance.
  • Liabilities, however, must be settled in full.

Key Takeaway:

  • Understanding the dual nature of value in a business is crucial for investors and lenders.
  • Earnings and assets are central to assessing a business’s financial health and potential.

Approaches to Asset Valuation

Three Main Valuation Categories:

  1. Cost-Based Valuation:
  • Based on the cost to create the asset.
  • Suitable for strategic investors, not typically for financial investors.
  • Relevant when choosing between buying and building an asset.
  1. Cash Flow-Based Valuation (Intrinsic Valuation):
  • Value assigned based on cash flow generated by the asset.
  • Involves discounting cash flow at a rate reflecting the expected return.
  • Two subcategories:
    • Risk Neutral Valuation: Adjusts cash flows for probability, discounted at risk-free rate. Common in insurance company valuations (embedded value, appraisal value).
    • Real World Valuation: Estimates likely cash flow, discounted at a rate including a risk premium.
  1. Selling Price-Based Approach (Relative Valuation):
  • Asset valued based on the price of similar assets.
  • Uses valuation ratios like P/E, P/B, EV/EBITDA.

Practical Application:

  • Cost-based valuation often requires technical assessment, less common among financial investors.
  • Focus on cash flow-based and selling price-based approaches for financial investment purposes.

Key Takeaway:

  • Different valuation approaches cater to different investor needs and asset characteristics.
  • Understanding each method’s context and applicability is crucial for accurate asset valuation.

Discounted Cash Flows Model for Business Valuation

  1. Basic Principle:
  • Value is derived from present value of future cash flows discounted at a certain rate.
  1. Bond Valuation Example:
  • Bond offers 9% annual interest, redeemable at end of 10 years for Rs. 100,000.
  • When coupon rate equals discount rate (9% here), bond’s value is its face value.
  • If expected return varies from coupon rate, bond value differs from face value.
  1. Application to Assets and Liabilities:
  • Approach applies universally, whether for bonds or equities.
  • Equity valuation considers dividends and sale proceeds instead of fixed coupons and redemption value.
  • Certainty in bonds vs. uncertainty in equities regarding cash flow amount and timing.
  1. Extending to Business Valuation:
  • Businesses valued based on earnings (cash flows) and terminal value (sale proceeds).
  • DCF models are sensitive to inputs; errors in judgement can occur due to uncertain future cash flows.
  1. Conditions for DCF Approach:
  • Requires knowledge of future cash flow stream, timing, and expected rate of return (discount rate).
  • Valuation involves computing present value of these expected cash flows.
  1. Valuing a Business with DCF:
  • Involves estimating Free Cash Flows (FCFs) over business’s life.
  • Present Value (PV) of FCFs calculated using an appropriate Discount Rate (DR).
  • Analyst variations in DCF estimates arise from differing assumptions on cash flows and discount rates.

Discounted Cash Flows (DCF) Model: A valuation method that calculates the present value of an investment based on its future cash flows. The model discounts these cash flows back to their present value using an appropriate discount rate, providing an estimate of what an investor would be willing to pay today for future returns.

Example: Bond Valuation Example: A bond with a 9% annual interest rate and a 10-year maturity, redeemable at Rs. 100,000. If the current interest rate is also 9%, the bond’s value today is its face value, Rs. 100,000. This is determined by discounting the future cash flows (interest payments and principal repayment) at the prevailing interest rate. If the expected rate of return differs from 9%, the bond’s value will adjust accordingly.

There are three different approaches to DCF models:

Dividend Discount Model (DDM)

  1. Concept Overview:
  • DDM values a company’s stock based on its expected future dividends.
  1. Discount Factor:
  • Future dividends are discounted using the company’s cost of capital.
  1. Applicability:
  • Best suited for companies that regularly pay substantial dividends.
  • More applicable to mature, stable companies, typically in defensive industries.
  1. Equity vs. Bonds:
  • Equities are considered to have a perpetual life, unlike bonds with fixed maturities.
  • Dividend payments are not contractual obligations as bond interest payments are.
  1. Estimates and Assumptions:
  • DDM requires making estimates about future dividend payments and growth rates.
  • These estimates can introduce a degree of uncertainty and subjectivity to the model.

Dividend Discount Model (DDM): A method of valuing a company’s stock price by using predicted dividends and discounting them back to their present value. The idea is to estimate the dividends a company will pay out in the future and discount them back to their present value to find the fair value of the stock.

Gordon Growth Model (Perpetual Growth Model)

  1. Model Purpose:
  • Used to value dividend-paying companies where dividends grow at a constant rate indefinitely.
  1. Formula Components:
  • P: Fair value of the company’s shares.
  • D1: Dividend expected at the end of the first year.
  • k: Cost of equity for the company.
  • g: Constant growth rate of dividends.
  1. Valuation Formula:
  • The Gordon Growth Model is expressed as



  1. Applicability:
  • Suitable for companies with stable, predictable dividend growth.
  • Assumes dividends grow perpetually at a consistent rate.
  1. Limitations:
  • The model relies on the assumption of a constant growth rate, which may not be realistic for all companies.
  • Accuracy depends on correct estimation of gg (growth rate) and kk (cost of equity).
  • Gordon Growth Model: This is a method for valuing a stock by assuming that dividends grow at a constant rate in perpetuity. The model calculates the present value of these future dividends to determine the fair value of the stock.

Free Cash Flow to Equity Model (FCFE)

  1. FCFE Overview:
  • An alternative to the Dividend Discount Model (DDM), especially for non-dividend-paying companies.
  • Values equity by discounting the free cash flow available to equity shareholders.
  1. FCFE Calculation:
  • Formula: Operating Cash Flow – Capital Expenditure – Interest Payments +/− Net Borrowings/Repayments = Free Cash Flow to Equity.
  1. Applicability:
  • Particularly useful for companies in a high growth phase.
  • Inappropriate to assume a constant growth rate for these companies due to potentially unsustainable high growth rates.
  1. Two-Stage Valuation Approach:
  • First Stage: Value the FCFE during the high growth phase.
  • Second Stage: Calculate the terminal value of perpetual FCFE post high growth phase, using a model like the Gordon Growth Model (with FCFE instead of dividends).
  • Terminal value must be discounted to its present value.
  1. Analyst’s Role:
  • Analysts need to estimate the duration of the high growth phase and calculate FCFE for that period.
  • They also need to discount these cash flows to the present value.
  • Free Cash Flow to Equity Model (FCFE): A valuation approach that focuses on discounting the free cash flows available to equity shareholders, rather than dividends, to determine the value of a company’s equity. This model is particularly suitable for companies that do not pay dividends, especially those in the high growth phase.

Free Cash Flow to Firm Model (FCFF)

  1. FCFF vs. FCFE:
  • FCFF is used when estimating net borrowings is subjective or biased.
  • Represents cash flow available to all capital sources, unlike FCFE which is for equity shareholders.
  1. FCFF Calculation Methods:
  • Direct Method: Operating Cash Flow – Capital Expenditure – Tax Benefit on Interest = FCFF.
  • Indirect Method: EBIT * (1 – Tax Rate) + Depreciation & Non-cash Charges – Change in Working Capital – Capital Expenditure = FCFF.
  1. Non-Cash Charges in FCFF:
  • Includes amortisation and losses/gains on asset sales.
  1. Valuing the Business with FCFF:
  • Discount FCFF to get Enterprise Value.
  • Use Weighted Average Cost of Capital (WACC) for discounting.
  • Deduct liabilities and add cash equivalents to derive Equity Value.
  1. Two-Stage Valuation in High Growth Companies:
  • Separate valuation for high growth phase and terminal value.
  • Terminal value often capped at the long-term GDP growth rate or assessed using multiples like EV/EBITDA.
  1. Discount Rate Considerations:
  • Reflects the risks and investor expectations.
  • For firm valuation, use WACC; for equity, use cost of equity.

Free Cash Flow to Firm Model (FCFF): A valuation model that calculates the cash flow available to all sources of a company’s capital before considering financial obligations. It’s particularly useful for valuing businesses where the net borrowings are uncertain or subjective. The model focuses on the total value of the business and involves using the WACC as the discount rate to determine the enterprise value.

Cost of Equity and Weighted Average Cost of Capital (WACC)

Cost of Debt:

  • Typically represented by the prevailing interest rates in the economy for borrowers with similar credit quality.

Cost of Equity (Ke):

  • The rate of return required by a company’s common shareholders.
  • Calculated using the Capital Asset Pricing Model (CAPM): Ke=Rf+β×(Rm−Rf)
  • Components of CAPM:
    • Rf: Risk-Free Rate of Return.
    • Rm – Rf: Market Risk Premium (MRP).
    • β: Company’s Beta, indicating stock volatility compared to the market.

Weighted Average Cost of Capital (WACC):

  • A measure combining the costs of equity and debt.
  • Formula:



  • Where:
    • Kd: Cost of Debt.
    • Tax: Corporate Tax Rate.
    • Equity, Debt: Market values of equity and debt, respectively.

Enterprise Value Calculation:

  • The enterprise value or equity value is derived by discounting the free cash flows at WACC.



Cost of Equity and WACC: Cost of equity represents the return expected by shareholders, determined using the CAPM formula. WACC is the average rate a company pays on its mixed debt and equity capital, reflecting the proportionate costs of each capital component adjusted for tax.

Relative Valuation

Relative valuation is a method to assess the value of a business by comparing it to similar businesses. This approach contrasts with Discounted Cash Flows (DCF), which attempts to find an absolute value.

Purpose of Valuation Exercises:

  • Aimed at determining whether a business is overpriced, underpriced, or fairly priced in the market.
  • Assists analysts in making investment recommendations like buy, sell, or hold.

Fundamental Concept:

  • Focuses on the comparison of ‘what we get’ (earnings and assets of the business) with ‘what we pay’ (the price).
  • By comparing these, analysts can assess whether a stock is cheap or expensive relative to its peers.

Price to Earnings (P/E) Ratio:

  • A common metric in relative valuation.
  • Calculated as Market Price per Share / Earnings per Share (EPS).
  • Indicates how much investors are willing to pay per unit of earnings.

Price to Book (P/B) Ratio:

  • Another frequently used relative valuation metric.
  • Calculated as Market Price per Share / Book Value per Share.
  • Useful in comparing the market’s valuation of a company to its book value.

Advantages of Relative Valuation:

  • Simpler and quicker than DCF as it requires fewer assumptions.
  • Easier for comparing companies within the same industry.


  • Relies on the assumption that the market is correctly valuing similar companies.
  • Can be misleading if peer companies are overvalued or undervalued.
  • Not as detailed or tailored to a specific company as the DCF method.

Application in Investment Decisions:

  • Used by analysts to quickly assess market sentiment about a company.
  • Helps in identifying potentially undervalued or overvalued stocks based on industry averages.

Contextual Use:

  • Best used in conjunction with other valuation methods for a more comprehensive analysis.
  • Particularly useful in industries where similar companies are plentiful and comparable.

Interpreting Ratios:

  • A lower P/E or P/B ratio may indicate a potentially undervalued company.
  • Conversely, a higher ratio might suggest overvaluation, although this can vary by industry norms.

Comparative Analysis: – Essential to compare companies that are similar in size, industry, and financial health. – Enables a more accurate and fair comparison.

Earnings Based Valuation Matrices

Dividend Yield and Price to Dividend Ratio

Topic Pointers:

  1. Dividends and Their Significance:
    • Dividends are part of a company’s profits distributed to shareholders.
    • They represent the company’s financial health and commitment to sharing success with investors.
    • Stable dividends suggest a balance between rewarding shareholders and reinvesting for growth.
  2. Dividend Yield:
    • Dividend Yield is a key indicator of how much a company pays out in dividends relative to its stock price.
    • Formula: Dividend Yield = Dividend per Share (DPS) / Current Stock Price.
    • A higher dividend yield can be attractive to investors seeking regular income.
  3. Price to Dividend Ratio:
    • This ratio measures how much the market is willing to pay for a company’s dividends.
    • Formula: Price to Dividend Ratio = Current Stock Price / DPS.
    • A lower ratio may indicate that the stock is undervalued relative to its dividend payout.
  4. Market Dynamics:
    • Dividend yields and price to dividend ratios fluctuate with market trends.
    • In bear markets, higher dividend yields may be found due to lower stock prices.
    • In bull markets, dividend yields typically decrease as stock prices rise.
  5. Comparative Analysis with Bond Yields:
    • Comparing dividend yields with bond yields helps assess the relative attractiveness of stocks versus bonds.
    • Stocks with dividend yields higher than bond yields might be undervalued or present better income opportunities.
    • However, a high dividend yield can sometimes indicate that the company has limited opportunities for reinvestment or growth.
  6. Interpreting High Dividend Payouts:
    • While high dividend payouts can be attractive, they may also suggest limited avenues for future company growth and investment.
    • This could potentially limit capital appreciation prospects for the stock.
  7. Tax Implications:
    • Understanding post-tax returns is crucial. For example, if bonds offer a 10% return but are taxed at 30%, their effective post-tax return is 7%.
    • In some regions, dividends might be tax-free for investors, making them more attractive on a post-tax basis.

Dividend Yield: The percentage of a company’s current stock price that is paid out as dividends each year.

Price to Dividend Ratio: A financial ratio that shows how much the market is willing to pay for every unit of dividend paid by the company.

Example: Consider a company consistently paying Rs. 5 as dividends per share. As the stock price varies, so do the dividend yield and the price to dividend ratio. 

For instance:

  • At a stock price of Rs. 50: Dividend Yield is 10% (5/50), and the Price to Dividend Ratio is 10 times (50/5).
  • At Rs. 100 per share: Dividend Yield falls to 5%, and the Price to Dividend Ratio increases to 20 times.

This pattern continues as the stock price increases, highlighting the inverse relationship between stock price and dividend yield, and the direct relationship with the price to dividend ratio.

Earning Yield and Price to Earnings Ratio

  1. Earning Yield:
    1. Definition: Earning Yield = Earnings Per Share (EPS) / Current price of stock.
    2. Usage: Used when dividend yields are low; indicates potential investment value in a stock.
    3. EPS: Represents net profit divided by the number of shares.
  2. Price to Earnings (PE) Ratio:
    1. Definition: PE Ratio = Current price of stock / Earnings Per Share (EPS).
    2. Reciprocal Relation: It’s the reciprocal of the Earning Yield.
    3. Interpretation: Shows how much an investor invests for 1 unit of profit.
    4. Types of PE Calculation:
      1. Historical PE: Uses historical EPS.
      2. Forward PE: Uses forecasted EPS.
    5. Investor Perception: A high PE ratio might indicate expectations of future growth or a company turnaround.
  3. Market Comparisons:
    1. High PE Ratio: Indicates a stock may be expensive compared to peers or market average.
    2. Low PE Ratio: Suggests a stock might be undervalued.
  4. Growth and Risk Considerations:
    1. High Growth or Low Risk: Such stocks might trade at a premium.
    2. Low Growth or High Risk: These might trade at a discount.
    3. Analyst Role: Need to consider growth potential and risk in valuation assessments.
  5. Earnings Period Relevance:
    1. Periodical Earnings vs. Price Point: Earnings are period-specific, while the price is at a particular point in time.
    2. Importance of EPS Period: Ensure EPS period is relevant from an investor’s viewpoint.
  6. Future Earnings Focus:
    1. Investor Tendency: More emphasis on estimated future earnings than past EPS.
    2. Subjectivity in Future Estimates: Selection of the EPS reference period can be subjective.
  • Earning Yield: A financial metric that measures the earnings generated from each dollar invested in a stock, calculated as EPS divided by the stock’s current price.
  • Price to Earnings Ratio: A valuation metric indicating the amount an investor pays for one dollar of a company’s earnings, calculated as the stock’s current price divided by its EPS.


  • Earning Yield: If a company’s EPS is $2 and its stock price is $40, the Earning Yield = $2 / $40 = 0.05 or 5%.
  • Price to Earnings Ratio: For the same company, the PE Ratio = $40 / $2 = 20. This means investors are willing to pay $20 for every $1 of earnings.

Growth Adjusted Price to Earnings Ratio (PEG Ratio)

  • Purpose: Addresses subjectivity in assessing stock value based on growth; incorporates growth rate into valuation.
  • Formula: PEG Ratio = (Current Price of Stock / Earnings Per Share) / Growth rate.
  • Origination: Coined by Peter Lynch, emphasizing the balance between high PE ratios and growth potential.
  • Lynch’s Insight: High PE ratios can be justified by high growthpotential, but warns of the potential temporary nature of high growth.
  • Valuation Benchmark:PEG ratio < 1 suggests undervaluation; > 1 may indicate overvaluation
  • Comparative Analysis: Useful for comparing attractiveness of different companies’ stock prices in relation to their growth prospects.
  • The Growth adjusted Price to Earnings Ratio, or PEG Ratio, is a metric that adjusts the traditional price to earnings (PE) ratio by incorporating the company’s expected growth rate. This adjustment provides a more nuanced view of a company’s value, especially for high-growth firms.


  • Company A Ltd: EPS = Rs.10, Stock Price = Rs.120 → PE Ratio = 12x, Growth Rate = 10% → PEG Ratio = 1.2x (12x/10).
  • Company B Ltd: EPS = Rs.10, Stock Price = Rs.140 → PE Ratio = 14x, Growth Rate = 15% → PEG Ratio = 0.93x (14x/15).
  • Comparative Conclusion: Despite a higher PE ratio, B Ltd’s lower PEG ratio (0.93x vs. 1.2x) indicates it might be a more attractive investment than A Ltd when considering growth prospects.

Enterprise Value to EBIT(DA) Ratio

  1. Capital Structure Impact: The return on equity is influenced by a business’s capital structure, which includes common equity, preferred share capital, and debt.
  2. Neutral Valuation Metric: Enterprise Value/EBIT or EV/EBITDA ratios are more suitable for acquirers as they are neutral to the company’s capital structure.
  3. Applicability in M&A: These ratios are particularly relevant when valuing a company from an acquirer’s perspective or when considering a potential acquisition.
    • EV/EBIT is generally preferred, except in capital-intensive industries where the historical cost of assets and depreciation methods can vary significantly.
    • In such industries, EV/EBITDA is more preferable due to its exclusion of depreciation and amortisation impacts.
  5. Comparative Valuation: Lower EV/EBIT(DA) ratios typically indicate more attractive valuation, but higher growth potential or lower risk can justify higher ratios.

Enterprise Value to EBIT(DA) Ratio is a valuation metric used in the context of mergers and acquisitions. It provides a capital structure neutral valuation by comparing a company’s enterprise value (EV) to its earnings before interest, taxes, depreciation, and amortisation (EBITDA) or to its earnings before interest and taxes (EBIT). This ratio is crucial in evaluating potential acquisition targets, particularly from an acquirer’s perspective.

Example: Consider two companies in the same industry but with different capital structures. While their P/E ratios might vary significantly due to their respective levels of debt and equity, their EV/EBIT or EV/EBITDA ratios would provide a more comparable and neutral basis for valuation.

In a capital-intensive industry, Company A might have a lower EV/EBIT ratio due to high depreciation costs, but its EV/EBITDA ratio would offer a clearer picture of its value compared to peers.

Enterprise Value (EV) to Sales Ratio

Topic Pointers:

  1. Limitation of Profit-Based Ratios: Ratios like P/E, EV/EBITDA, and EV/EBIT are less useful or inapplicable for companies experiencing losses, as these metrics are profit-based.
  2. Relevance for Break-Even Companies: Companies that have recently reached break-even may show deceptively high values in profit-based ratios due to low profit figures. This makes such ratios less meaningful for evaluating these companies.
  3. EV/Sales for Low/No Profit Companies: The EV/Sales ratio becomes a more meaningful metric in these scenarios, as sales figures are always non-negative, unlike profit metrics.
  4. Applicability Criteria: EV/Sales is most suitable for companies expected to become profitable and maintain profitability in the future.
  5. Valuing Loss-Making Companies: For companies with ongoing losses and no foreseeable turnaround, the valuation should be based on liquidation value rather than the EV/Sales ratio.

Enterprise Value (EV) to Sales Ratio is a valuation metric used for companies where profit-based ratios like P/E, EV/EBITDA, or EV/EBIT are not applicable, typically in scenarios where the company is not profitable. This ratio compares the enterprise value of a company to its sales, providing a meaningful valuation metric for companies with low or no profits but expected to be profitable in the future.

Example: Imagine a startup company that has just achieved break-even status. Its profits are minimal, making the P/E ratio exceedingly high and misleading. However, its sales figures are robust and growing. In this case, the EV/Sales ratio offers a more realistic assessment of the company’s value, focusing on its revenue generation rather than its current minimal profits.

Assets Based Valuation Matrices

Topic Pointers:

  1. Focus Shift to Assets: Unlike the previous section focusing on earnings, this approach emphasises balance sheet variables, using assets to identify business value.
  2. Key Ratios:
    • Return on Equity (ROE): Calculated as Net Profits / Equity Capital (or Net-worth). This ratio measures the profitability relative to shareholders’ equity.
    • Return on Capital Employed (ROCE): Calculated as EBIT / Total Capital Employed (Debt + Net-worth). It indicates the efficiency and profitability of capital investments.
  3. Importance of ROE and ROCE: These ratios are crucial in showing how effectively a business allocates its capital and the returns it generates on the book values of equity and combined equity and debt.
  4. Investor Perspective – Return on Invested Capital (ROIC): Defined as Earnings / Invested Capital. This ratio is particularly important for investors, as it reflects the return on the actual capital they have invested, rather than on book values.





Assets Based Valuation Matrices involve using balance sheet variables, particularly assets, to determine the value of a business. This approach includes ratios like Return on Equity (ROE) and Return on Capital Employed (ROCE), which focus on the returns generated on equity and total capital employed. Additionally, Return on Invested Capital (ROIC) is used to assess the return on actual capital invested by investors, providing a more relevant measure for investment decisions.

Example: Consider a company with net profits of $100,000 and equity capital of $500,000. The ROE would be calculated as $100,000 / $500,000 = 20%. 

This indicates a 20% return on the shareholders’ equity.

If the same company has a total capital employed (debt + net-worth) of $1,000,000, and its EBIT is $150,000, the ROCE would be $150,000 / $1,000,000 = 15%. This reflects the efficiency of the company in using its total capital to generate profits.

Price to Book Value Ratio

Topic Pointers:

  1. Focus on Ownership Interest: Unlike profit-based ratios like P/E or EV/EBIT(DA), the Price to Book Value (P/B) ratio measures the investment required to gain ownership interest in a company.
  2. Calculation Methods:
    • P/B Ratio = Market Capitalization / Balance Sheet Value of Equity
    • Alternatively, P/B Ratio = Price Per Share / Book Value Per Share
  3. Investment Measurement: This ratio indicates the amount an investor must invest to acquire one unit of net assets of the company.
  4. Sector Preference:
    • More favored in the financial sector due to the reliability of book value numbers.
    • Less reflective of fair value in capital-intensive industries and sectors like technology and services, where balance sheet values don’t capture significant assets like human capital and intellectual properties.
  5. Conservative Value Assessment: Reflects a conservative estimate of equity value, especially useful when seeking to determine a lower-bound value.
  6. Comparative Value: Lower P/B ratios generally suggest more attractive valuations. Companies with higher ROE may command a premium due to more efficient equity usage.

Price to Book Value Ratio is a financial metric that compares the market price of a company’s shares to its book value per share. It provides insight into how much investors are willing to pay for each dollar of net assets owned by the company, offering a perspective on the company’s valuation that is distinct from earnings-based metrics.


  • AFB Finance: Market Price Per Share = Rs. 200; Total Equity = Rs. 9,900 lakhs; Shares = 50 lakhs. Book Value Per Share (BVPS) = Rs. 9,900 lakhs / 50 lakhs = Rs. 198. P/B Ratio = Rs. 200 / Rs. 198 = 1.01.
  • LKH Finance: Market Price Per Share = Rs. 175; Total Equity = Rs. 8,000 lakhs; Shares = 50 lakhs. Book Value Per Share (BVPS) = Rs. 8,000 lakhs / 50 lakhs = Rs. 160. P/B Ratio = Rs. 175 / Rs. 160 = 1.09.
  • Comparison: AFB Finance, with a P/B Ratio of 1.01, is less expensive compared to LKH Finance’s 1.09, suggesting a more attractive valuation relative to its book value.

Enterprise Value (EV) to Capital Employed Ratio

Topic Pointers:

  1. Enterprise Value Components:
    • EV = Value of Equity + Value of Debt – Cash and Cash Equivalents.
  2. Ratio Calculation:
    • EV to Capital Employed Ratio = Enterprise Value / Capital Employed.
    • Capital Employed is the sum of Total Equity and Total Debt.
  3. Investment Decision Aid:
    • This ratio, in conjunction with the Return on Capital Employed (ROCE), aids in assessing the return on invested capital, facilitating informed investment decisions.
  4. Interpreting the Ratio:
    • A higher EV to Capital Employed Ratio implies that the investor is paying more relative to the capital employed in the business.
    • Comparing this ratio with ROCE helps in evaluating whether the investment generates an adequate return.

The Enterprise Value to Capital Employed Ratio is a financial metric that compares a company’s total enterprise value to its capital employed. This ratio is significant in investment decision-making, helping investors understand how much they are paying for each unit of capital employed in the business.


  • Consider a business with a net-worth of Rs. 100,000, debt of Rs. 100,000, and a market capitalization of Rs. 500,000. The business has no cash and cash equivalents, and its ROCE is 45%.
  • Capital Employed Calculation: 100,000 (Net-worth) + 100,000 (Debt) = 200,000.
  • EV Calculation: 500,000 (Value of Equity) + 100,000 (Value of Debt) = 600,000.
  • EV to Capital Employed Ratio: 600,000 / 200,000 = 3.
  • Interpretation: With an ROCE of 45%, and an EV 3 times the capital employed, the return generated is effectively one third of the ROCE, i.e., 15%. If an investor seeks at least a 20% return, they would not pay more than 2.25 times (45/20) the capital employed, or Rs. 450,000 in this case.

Net Asset Value Approach

Topic Pointers:

  1. NAV Composition:
    • Net Asset Value (NAV) is calculated as the market value of a company’s assets minus the value of its liabilities.
  2. Market Value vs. Book Value:
    • Unlike net-worth or book value that uses the book value of assets, NAV uses the market value of assets, offering a more current valuation.
  3. Equity Value Calculation:
    • NAV can represent the total equity value of a company. It can also be divided by the number of outstanding shares to find the net asset value per share.
  4. Application in Asset-Intensive Industries:
    • The NAV approach is particularly useful in asset-oriented businesses like real estate, shipping, and aviation, where the current market value of assets is a significant indicator of the company’s value.

Net Asset Value (NAV) of equity is a valuation method that involves subtracting the value of a company’s liabilities from the market value of its assets. This approach provides a current valuation of a company’s equity, differing from book value or net-worth, which are based on the historical cost of assets.

Example: In the real estate sector, a company’s NAV could be calculated by taking the current market value of its property holdings and other assets, subtracting any outstanding liabilities. If the market value of the assets is Rs. 1,000,000 and liabilities amount to Rs. 300,000, the NAV would be Rs. 700,000. If the company has 100,000 outstanding shares, the NAV per share would be Rs. 7. This provides a more realistic picture of the company’s value per share based on current market conditions, as opposed to using book values.

Other Valuation Metrics

Topic Pointers:

  1. Price/Embedded Value:
    • Used specifically in the life insurance industry.
    • Embedded Value: Present value of expected net future cash flows (adjusted for probability) from in-force policies.
    • This ratio is critical for valuing life insurers.
  2. Price/Adjusted Book Value (ABV):
    • ABV: Fair value of asset minus fair value of liabilities.
    • Incorporates off-balance sheet items, unlike traditional book value.
    • Useful for valuing Non-Banking Financial Companies (NBFCs).
  3. EV/Capacity:
    • Relevant in scenarios where financial metrics don’t reflect potential value, like in start-ups or companies in special situations.
    • For instance, valuing a steel plant based on production capacity, or an e-commerce start-up based on user metrics (number of users, transactions, or transaction value).

These alternative valuation ratios are used depending on the specific industry and scenario. They include Price/Embedded Value for life insurance businesses, Price/Adjusted Book Value for NBFCs, and EV/Capacity, particularly for start-ups and companies in unique situations. These metrics provide a more nuanced valuation approach, capturing aspects not reflected in traditional financial ratios.


  • Life Insurance Company: If the embedded value of a life insurance company is Rs. 500 crores and its market price is Rs. 600 crores, the Price/Embedded Value ratio would be 1.2 (Rs. 600 crores / Rs. 500 crores).
  • NBFC: For an NBFC with an adjusted book value of Rs. 200 crores and a market price of Rs. 250 crores, the Price/ABV ratio would be 1.25 (Rs. 250 crores / Rs. 200 crores).
  • E-commerce Startup: An e-commerce startup might be valued at Rs. 300 crores with an annual transaction value of Rs. 100 crores, leading to an EV/Transaction Value ratio of 3 (Rs. 300 crores / Rs. 100 crores).

Relative Valuations – Trading and Transaction Multiples

Topic Pointers:

  1. Intuitive Approach:
    • Relative valuation involves valuing an asset by comparing it to similar assets in the market.
    • It’s a common, intuitive practice, akin to how real estate is often valued.
  2. Market Price Comparisons:
    • This method estimates value based on the pricing of comparable assets in the same locality or industry.
  3. Influenced by Market Mood:
    • Reflects current market sentiment, which can be overly optimistic or pessimistic.
    • Important to use range parameters (maximum, minimum, average) to balance this effect.
  4. Historical and Peer Comparison:
    • Involves analyzing earnings and assets-based valuation parameters historically and against industry peers.
    • Helps in determining if an asset is relatively cheap or expensive.
  5. Types of Multiples:
    • Trading Multiples: Derived from stock market data.
    • Transaction Multiples: Based on other similar transactions in the industry.

Relative valuation is a method of valuing an asset by comparing it to the prices of similar or comparable assets in the market. This approach is intuitive and straightforward, often used for quick estimates of value with limited computations. It includes using trading multiples from the stock market and transaction multiples from industry-specific deals.

Example: In the context of real estate, if apartments in a particular area are selling for around Rs. 50 lakhs, a similar apartment would likely be valued in that range, forming a basis for negotiation.

For a publicly traded company, if the average P/E ratio in its industry is 15 and the company’s P/E ratio is 10, it might be considered undervalued relative to its peers.

Sum-Of-The-Parts (SOTP) Valuation

Topic Pointers:

  1. Applicable to Diversified Businesses:
    • SOTP valuation is best suited for corporations operating multiple, diverse business units under one umbrella (e.g., ITC, L&T).
  2. Separate Valuation of Business Units:
    • Each business segment is valued independently, using appropriate valuation methods (earnings-based, assets-based, etc.).
  3. Aggregation of Individual Values:
    • After valuing each segment separately, these valuations are summed to determine the total value of the conglomerate.
  4. Independence of Business Verticals:
    • In SOTP valuation, each business vertical is treated as a standalone entity for valuation purposes.

Sum-Of-The-Parts (SOTP) Valuation is a method of valuing a diversified company by separately assessing the value of each of its business units and then adding these values together. This approach is particularly useful for conglomerates with distinct business segments, ensuring a more accurate valuation by considering the unique aspects and performance of each division.

Example: Consider a conglomerate with three main business units: Unit A valued at Rs. 100 crores, Unit B at Rs. 200 crores, and Unit C at Rs. 150 crores. Using the SOTP method, the total value of the conglomerate would be the sum of these individual valuations, totaling Rs. 450 crores. This approach acknowledges that each unit contributes uniquely to the conglomerate’s overall value, rather than assessing the conglomerate as a single, homogeneous entity.

Valuation Parameters in New Age Economy and Businesses

Topic Pointers:

  1. Complex Valuations: Valuations of new age businesses like E-commerce and tech companies are challenging due to unconventional parameters.
  2. Traditional vs New Metrics: Traditional valuation methods struggle with these companies, leading to reliance on new metrics such as eyeballs, page reviews, footfall, Average Revenue Per User (ARPU), and user count.
  3. Profit Expectation: As per Warren Buffett’s perspective, these metrics should eventually lead to profits for owners. Without profit visibility, valuations are speculative.
  4. Market Belief and Sustainability: Valuations are sustained as long as there is a compelling story, market belief, and potential buyers. Absence of these factors can lead to a collapse in valuation, as observed during the dot-com bubble (2000-2001).

Valuation in the context of new age economy and businesses refers to the process of determining the worth of companies, especially in sectors like E-commerce and technology, using unconventional parameters beyond traditional financial metrics. This involves assessing factors like online engagement, user base, and growth potential in the absence of immediate profitability.


Dot-com Bubble: A classic example is the dot-com bubble of 2000-2001, where excessive speculation in internet-based companies led to inflated valuations. Many of these valuations collapsed due to lack of sustainable profits and market belief.

Capital Asset Pricing Model (CAPM) and Discounted Cash Flows (DCF) Model

Topic Pointers:

  1. Capital Asset Pricing Model (CAPM): 
  2. Discounted Cash Flows (DCF) Model for Business Valuation: A method to value a business or an investment by discounting future cash flows to present value.
  3. Bond Valuation Example:
    • Bond Details: Offers 9% interest per annum, redeemable at the end of 10 years, face value Rs. 100,000.
    • Current Interest Rates: Also 9% for similar maturity and credit quality.
    • Value Determination: Based on the present value of future cash flows discounted at the prevailing 9% rate.
    • Equal Coupon and Discount Rate: If coupon rate equals the discount rate, the bond’s value equals its face value (Rs. 100,000).
    • Rate Variations: Bond value decreases if the expected rate of return is higher than 9%, and increases if it is lower.

Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return for assets, particularly stocks.

Discounted Cash Flows Model (DCF): A valuation method used to estimate the value of an investment based on its expected future cash flows.


Bond Valuation: A bond offering 9% interest per annum with a redemption value of Rs. 100,000 after 10 years. If the prevailing interest rates are also 9%, the bond’s value today would be its face value, Rs. 100,000. This is calculated using the present value of future cash flows, considering the interest rate as the discount factor.

Objectivity of Valuations in Business

Topic Pointers:

  1. Subjectivity in Valuation: Despite numerous computations, valuation remains a subjective exercise.
  2. Subjective Inputs: The inputs used in various valuation methods lack universally accepted standards, contributing to subjectivity.
  3. Time Sensitivity: Valuation is not static and can change significantly with the changing circumstances of the business.
  4. Misconception of Precision: Using complicated quantitative models may give a false impression of precision in valuation.

Objectivity of Valuations: The concept refers to the degree of impartiality and unbiasedness in the valuation process. However, in practice, valuations often contain a subjective element due to variable inputs and changing business environments.

Important Considerations in Business Valuation

  1. Earning Power vs. Book Value (BV):
  • High earning power reduces the emphasis on the book value of shares.
  • Low earning power increases the importance of book value.
  1. Valuing Shares and the Entire Business:
  • Share valuation requires an assessment of the entire business, as a share represents a part of the business ownership.
  1. Enterprise Value (EV) vs. Market Capitalization:
  • Enterprise Value, rather than market capitalization, reflects the true value of a firm for private owners.
  1. PE Ratio and Leverage:
  • Price-to-Earnings (PE) ratio can be misleading in highly leveraged firms; the firm’s debt level should be considered.
  1. Consolidated Numbers vs. Standalone Numbers:
  • Use consolidated financials for a more comprehensive understanding, as opposed to standalone figures.
  1. Focus on ROE and Retained Earnings:
  • Prioritize Return on Equity (ROE), since Earnings Per Share (EPS) doesn’t account for retained earnings.
  1. Leverage and ROE:
  • While leverage can boost ROE, excessive leverage is risky and can distort financial health.
  1. Distinguish ROCE and ROE:
  • Return on Capital Employed (ROCE) offers a true reflection of capital return, whereas ROE can be skewed by high leverage.
  1. Alignment of ROCE and ROE:
  • A close correlation between ROCE and ROE is ideal; significant differences warrant further analysis.

Important Considerations in Business Valuation: This concept encompasses various factors crucial in assessing a business’s value. It includes understanding the interplay between earning power and book value, the need to value the whole business for accurate share valuation,recognising the superiority of Enterprise Value over Market Capitalization for private ownership assessment, the impact of leverage on PE ratio, the preference for consolidated financials over standalone, the significance of ROE and the influence of retained earnings, the role of leverage in affecting ROE, and the necessity to distinguish and align ROCE with ROE for a thorough financial evaluation.

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