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.

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