POPULAR METHOD Less Time and Resource Intensive as Compared to DCF. Easy to Understand and Communicate to Clients.

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Gervase Tracy Flowers
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2 POPULAR METHOD Less Time and Resource Intensive as Compared to DCF. Easy to Understand and Communicate to Clients. Can be Defended Easily Reflects the Current Market Mood.

3 PITFALLS Inconsistent estimates of value where key variables risk,growth and cash flow potential) are ignored Values move with market moods Lack of transparency in Underlying Assumptions Vulnerable to manipulation and biases

4 IC STEPS USING MULTIPLES fine consistently and clearly ( Example:- Different variations of P.E Ratio) gical choice of numerator and denominator( Example :-Equity Value with ity Value) niform application across firms. (Example e:-different Accounting Standards les /Closing Year) Description Tests utliers and Averages iases due to elimination

5 lytical Tests at are the fundamentals that affect the multiple w will the multiple react to changes in these fundamentals terminants of the multiples arethe same as before risk, growth and sh flow potential

6 tive Valuations vis-à-vis DCF F assumes markets may be wrong at overall level and at firm level ative Valuation assumes markets are right are overall level and could rong at firm level s, you could find a stock overvalued on DCF basis, but undervalued lative basis if the sector is overvalued

7 E EARNING RATIO (P.E RATIO) = Market Price Per Share/ Earning per Share ost Widely Used Tool due to Easy Availability and Understanding gically Defined both relate to an Equity Share Common Parlance Low P.E = Undervaluation and Vice Versa E Tool to Estimate Simple Payback Period

8 OGICAL STEPS IN DERIVING P.E djusting for Diluted Earnings w.r.t ESOPS dging the probabilities of Future Conversions. moving The effect of Extraordinary Adjustments/One Offs. sing Similar Earnings for Comparison like Trailing, Forward, rrent, Basic or Diluted

9 SOME EXAMPLES /CASE STUDIES IN P.E ADJUSTMENT LOSS MAKING COMPANIES/ CYCLICAL COMPANIES oss is due to one off Factors OR due to Cyclical Nature of the Busines aking Average of last 5 years OR the Entire Cycle. lso using other ratios to come to a logical conclusion bove Steps to enable a Measured Decision

10 CEMENT Domestic Cyclical Company) YEAR EPS ERAGE EPS SANGHVI MOVERS ( A Domestic Cyclical Company) YEAR EPS AVERA AGE EPS 13.8 ICE 640 TEST P.E 47.8 PRICE LATEST T P.E 180 N.A BASED ON AVERAGE EPS 29.0 CTOR P.E 32.0 P.E BASED ON AVERAGE EPS 13.1 SECTOR P.E 26.0 RCE:- CAPITALINE SOURCE:- CAPITALINE

11 BANKING AND FINANCIAL COMPANIES nique Nature of Business makes at times using P.E misleading s all Assets are priced at Current Value, P/BV a more apt measure ore Detailed Discussion at time of P/BV discussion.

12 MPANIES WITH HIGH FINANCIAL LEVERAGE rnings depressed due to high leverage. ratio is at elevated levels h Financial Leverage may be due to Faulty Capital Structure or Prevailing High Intere h Financial Leverage correction may happen via New equity issuance or Debt Refin /EBIDTA is a better tool in such a scenario

13 CF Perspective with regards to PE PE Multiples derivation from DCF Formulae PE Multiple is positively impacted by growth (both in high growth period and stable period) PE Multiple is negatively impacted by risk PE Multiple is positively impacted by return on equity

14 Multiples across time mparison of current multiples with history is very common wever, if underlying fundamentals have changed, such historical comparison may not be valid increase in interest rates should result in higher cost of equity and a lower PE multiple greater propensity to take risks will result in a lower risk premium expectation and thus lower cost quity and increase PE multiples increase in expected growth rates will increase PE multiples increase in return on equity will increase PE multiples

15 ultiples across countries ntries with higher real interest rates would have lower PE Multiples ntries with higher expected real growth rates will have higher PE Multi ntries which are viewed to be high risk and would hence require higher ums would carry lower PE Multiples. ntries which are more efficient and r PE Multiples hence earn higher ROE will have

16 Ratio G Ratio = PE Multiple / Expected Growth Rate Growth is on current year s earnings, PE should be Current PE Growth is based on trailing earnings, PE should be Trailing PE rward PE is never used as it will result in double counting

17 rprise Value to EBIDTA e of the Most Theoratically strong multiple. level multiple er firms with negative EBIDTA as compared to negative EPS hence, fewer firm aggregation reciation policy differences impact on EPS eliminated in EBIDTA parable across companies with different leverage levels ly Core Operating Earnings are concerned idely used in Mergers and Acquisitions

18 BIDTA / EBIDTA = (Market Value of Equity +MV of Debt Cash) / EBIDTA netted out of numerator rest Income netted out of EBIDTA iculties in case of investments in subsidiaries and s ) are not fully recognized joint ventures as incomes ok Value of Debt is normally taken ( as in India we don t have a thriving Bond Market)

19 TATA MOTORS ( CONSOLIDATED) (IN CRORES) (IN CRORES) (IN CRORES) Market Price EPS P.E RATIO NET DEBT MARKET CAP EV EBIDTA EV/ ce:- Capitaline

20 ultiple Perspectives s with lower tax rates should command higher multiples her depreciation and amortisation levels should result in lower multipl her reinvestment requirements should depress the multiple s with lower cost of capital should enjoy higher multiples s with higher expected growth should enjoy higher multiples

21 e to Book (Adjustments) ok Value however affected by accounting policies mparisons across countries may be difficult me firms especially tech may have low book values and hence very high ratios justments for acquisition accounting may be difficult and complex echnological changes may make Assets redundant. (ex Camera Film Roll, Pagers) ood Will needs to be looked at in Detail. (Case Study)

22 TATA STEEL BOOK VALUE (Impairment Charge of Rs. 88 Per share) US ACQUISITION DWILL IMPAIRMENT CHARGE cal Time Lag between Error and Admission seems to be about 5 years ( Source : ECONOMIST ce :- italine

23 BV Perspectives PBV increases with higher ROE PBV increases with a higher payout ratio PBV decreases with a higher Cost of Equity PBV increases as growth rate increases

24 pplications [part 1] investors use PBV as a screen to pick undervalued stocks rs combine this with other fundamentals to pick undervalued stocks ROE combined with Low PBV is taken as a proxy for low risk h Usage in Valuing Banks and Financial Stocks as no Historical Bias in their ance Sheet. and French concluded that firms in the Low PBV class earned 1.83% per month t High PBV firms earning 0.30% during 1963 to 1990

25 Applications [part 2] jamin Graham uses price to be lesss than 2/3rd of book value as a ion since 1934 odaran tested low PBV portfolios (with high ROE) and found they d 25.6% annually against S&P earning 17.49% during reverse portfolio (high PBV and low ROE) earned 10.61% in this d

26 ICICI BANK AXIS BANK HDFC BANK YES BANK PRICE 350 BV AS ON MARCH P/BV 2.8 ROE 14% P.E 21 Source :- Capitaline % 21% 25%

27 PANY PRICE BV P/BV EPS ROE Rational Cost of Equity Implied P/BV Implied Cost of Equity P.E LE % 12% % % 12% % % 12% % 32.1 SUMER % 12% % 45.0 GATE % 12% % 46.1 GH ROE /HIGH BV COMPANIES

28 nue Multiples enues cannot be negative unlike EPS or EBIDTA enues are not so much influenced by accounting policies as EPS or EBIDTA enues are less volatile than EPS or EBIDTA dvantage it can lull you into investing into high revenue low profit firms cent Investments in Firms Like Flipkart, ltiples Snapdeal are done on these ed by Venture Capital Firms.

29 mparison OF Shares with Differential Voting Rights PRICE P TA MOTORS TA MOTORS DVR rries 1/10 Right of Normal Share) titled to 5% Higher Dividend) (A discount of 31%) 7 rce :- Capitaline Is Such a Big Discount Justified?

30 s Issued at a discount of 10% By Company in 2008 ationally Shares with Differential Voting Rights Trade at 5-10 % Discount LE C SHARE ies No voting Right) LE A SHARE ies 1 Vote for Every 1 Shares) $528 ( Discount of less than $537 LE B SHARE ( Held by Promoters) ies 10 Vote for Every 1 Shares)

31 Valuation is an Art with Skepticism derive financial ratios from the financial statements. While these ratios do help an investor port a value investment analysis, investing is not a paint by numbers exercise. ticism and judgement are always required. For one thing, not all factors affecting value are ed in a Company s financial statement for example Inventories can become obsolete, ables uncollectible, liabilities are sometimes unrecordedand asset values over or stated. ndly Valuation is an art, not a science. As the value of a business depends on numerous les, it can be typically assessed only in a range., the outcomes of all investments depend to some extent on the future, which cannot be ted with certainty; for this reason, even some carefully analysed investments fail to achieve ble outcomes. Sometimes a stock may become cheap for good reason like a failed business l, hidden liabilities, protracted litigation or incompetent or corrupt management.

32 Investment must always be practiced with caution and humility, and with a relentless search for additional information while realizing that you will never know everything about a company. In the end, the most successful investors combine detailed business research and valuation work with endless discipline and patience, intellectual honesty, sensitivity analysis and years of analytical and investment experience.

33 THANK YOU

Relative vs. fundamental valuation

Relative Valuation Relative vs. fundamental valuation The DCF model is a method of fundamental valuation. Value of equity is the present value of future cash flows. Ignores the current level of the stock