Chapter 32

Business Valuation
Presenter: Prof. Rajsee Joshi N.R. Institute of Business Management GLS Institute of Computer Technology-MBA

Approaches/Methods of Valuation
There are four approaches to valuation of business (with focus on equity share valuation): 1) Assets based
2) Earnings based 3) Market value based

4) Fair value method

Price Earnings (P/E) Ratio

The P/E ratio (also known as the P/E multiple) is the method most widely used by finance managers, investment analysts and equity shareholders to arrive at the market price of an equity share. The application of this method primarily requires the determination of earnings per equity share (EPS). The EPS is computed as per Equation EPS = Net earnings available to equity shareholders during the period/Number of equity shares outstanding during the period. (5) The EPS is to be multiplied by the P/E ratio to arrive at the market price of equity share (MPS). MPS= EPS P/E ratio The P/E ratio may be derived given the MPS and EPS. (6)

P/E ratio = MPS/EPS

(7)

Example Company has future maintainable profits after taxes as Rs. 78 lakhs (i) The company has 1,00,000 11% Preference shares of Rs 100 each, fully paid-up. (ii) The company has 4,00,000 Equity shares of Rs 100 each, fully paid- up. (iii) P/E ratio is 8 times. Solution Determination of Market Price of Equity Share Future maintainable profits after taxes Less: Preference dividends (1,00,000 Rs 11) Earnings available to equity-holders Divided by number of equity shares Earnings per share (Rs 67 lakh/4 lakh) Multiplied by P/E ratio (times) Market price per share (Rs 16.75 8) Value of Business is MPS x no. of outstanding shares Rs 78,00,000 11,00,000 67,00,000 4,00,000 16.75 8 Rs 134 Rs 536,00,000

Computation of Free-Cash Flows to the firm

After tax operating earnings (including interest cost) Plus: Depreciation & Other non-cash items Less: Investment in long-term assets Less: Investment in operating net working capital_______________________ Operating free cash flows (OFCF) Plus: After-tax non-operating income/CF Plus: Decrease in non-operating assets_______________________________ Free Cash flows to the firm (FCFF)

Value of Firm0

FCFF to all investorst 1 k 0 t t 1

Alternatively, the value of equity can be determined directly by discounting the free cash flows available to equityholders (FCFE) after meeting interest, preference dividends and principal payments, the discount rate being ke, that is,

Value of Equity0

FCFF to equityhold t ers 1 k e t t 1

Market Value Based Approach to Valuation

The

market value (reflected in the stock market quotations) is the most widely used approach to determine the value of a business, in particular of large listed firms.
The

market value indicates the price the investors are willing to pay for the firms earning potentials and the corresponding risk.
This

method is particularly useful in deciding swap ratios in the case of merger decisions.
Usually,

12 months average of stock prices or the average of high & low values of stocks during a year can be taken.
Market

value per share x no. of outstanding shares = value of business

Fair Value Method

Fair The

value method is not an independent method of share valuation.

method uses the average/weighted average of two or more of the above methods.
Therefore,

such a method helps in smoothening out wide variations caused by different methods and indicates the balanced figure of valuation.

Valuation Relative to Industry Averages

1. Dividend Yield Method: Value per share = Co.s dividend per share x Nominal Value of share Industrys avg. div. per share Value of business = value per share x no. of o/s shares
2. Earnings yield method: Value of business = Cos expected future maintainable profits Industrys normal earnings yield 3. Return on Capital employed: Value of business = Cos expected future maintainable profits Industrys normal rate of return on capital employed

Valuation Relative to Industry Averages

4. Price/Earnings (P/E Ratio) method: Value of business = Cos expected future maintainable profits x Industrys average P/E Ratio

Discounted Cash Flow Valuation Models

1.
2.

3.

4.

Discounted Dividend Model (two-stage growth model) Discounted Cash-Flow Model (Continuing Value method) Discounted IRR Method (Instead of cost of capital (k), IRR is used to discount the cash flows and determine the present value Discounted EVA method

Theoretical Valuation Models

1.
2. 3. 4.

Dividend Growth Model (Gordons Model) Walters Valuation Model MMs Dividend Model CAPM Model (used in determining the rate of return from equity ke

Valuation based on Cos fundamentals

1. Revenue or Sales multiple: Business Value = _ROCE g x (1-T) m Sales ROCE x(k-g) m = profit margin
2. Operating profit multiple: Business Value = ROCE g x (1-T) (1-D)g EBIDT ROCE x(k-g) 3. Operating multiple: Business Value = ROCE g x NOPAT Unit ROCE x(k-g) unit

Valuation based on Cos fundamentals

4. P/E Multiple: Market price per share = ROE g__ EPS ROE x (k-g) 5. Price/Book Value multiple: Market price per share = ROE g_ x ROE Book value per share ROE x (k-g)

Market Value Added (MVA)

The market value added (MVA) approach measures the change in the value of the firm from the perspective of all the providers of funds (i.e., shareholders as well as debentureholders).
MVA = [Total market value of the firms securities (Equity shareholder funds + Preference share capital + Debentures)] The MVA from the point of view of equity shareholders is = (Market value of firms equity Equity funds)

Example
Supreme Industries has an equity market capitalisation of Rs 3,400 crore in current year. Assume further that its equity share capital is Rs 2,000 crore and its retained earnings are Rs 600 crore. Determine the MVA and interpret it. Solution MVA = (Rs 3,400 core Rs 2,600 crore) = Rs 800 crore. The value of Rs 800 crore implies that the management of Supreme Industries has created wealth/value to the extent of Rs 800 crore for its equity shareholders. Well managed companies, having good growth prospects, and perceived so by the investors, have positive MVA. Investors may be willing to pay more than the net worth. In contrast, companies relatively less known or engaged in businesses that do not hold future growth potentials may have negative MVA.

Example Hypothetical Limited has equity market capitalisation of Rs 900 crore in the current year. Its equity share capital and accumulated losses are of Rs 1,200 crore and Rs 200 crore respectively. Determine the MVA of the firm. Solution MVA = (Rs 900 crore Rs 1,000 crore) = (Rs 100 crore). The firm has negative MVA of Rs 100 crore. The investors discount its value/worth, as it is loss incurring firm. The market value added approach reflects market expectations and is essentially a future-oriented and forward looking approach. The investors, willing to pay a different price (other than one suggested by book value), are guided by the individual companys future prospects, future growth rates, risk complexion of the firm, industry to which the firm belongs, required rate of return and so on.

Thank You