BFSI & Capital Markets Study Group

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1 BFSI & Capital Markets Study Group - Wirc of Icai - Empowering Excellence Roundtable Discussion / Think Tank Meeting Venue : BKC Date : 31/10/2015 Topics : Applied Financial Analysis and Forecasting Financials / Financial Modelling with Case Studies BFSI & Capital Markets Study Group -Wirc of Icai

2 What is value? We see a quarter of bad earning, and the stock price falls. But does a bad quarter have any impact on the value of a business? The value of a business is decided by what the business can earn in its lifetime. 31 October

3 Simple illustration Example 1: Papa Patisserie is an established business. We know its earnings for the next 30+ years. It earns Rs. 1,00,000 every year. It will earn Rs. 30,00,00 in 30 years, but not all at once. FD rate is 6% If we invest Rs. 1,00,000 every year in a bank, we get Rs. 1, 06,000 at the end of the year. Rs. 1,00,000 earned with an opportunity cost of 6% gives a values of Rs. 16,66, October

4 Problems faced We had assumed earnings are known and are constant. Will they actually grow, or will they fall? Will the business be even around in 30 years? Predicting so far ahead is pretty hard. Most businesses are more complicated than your regular patisserie In fact most analysts have a hard time predicting your next quarter or next year Example: cement sector There is risk to our earnings forecast. Even if the 31 October guess is vey smart, it is still a guess.

5 More questions What would you pay more for? A guaranteed Rs. 100,000 for the next 30+ years, or, a best guess of collecting Rs. 100,000 for the next 30+ years For a guaranteed Rs. 100,000 we discount at 6%, for, a best guess of collecting Rs. 100,000 we discount at a higher rate. It can be 8%, 10% or 12% (depending on how confident we are about are estimate.) Different valuations at different rates 6% : Rs.16,66,667 8% : Rs.12,50,000 12%: Rs. 8,33, October So figuring out the right discount rate is a problem

6 .. contd Companies also do not have same income each year. So value also depends on estimate of growth Estimates at different assumptions 4% growth/ 8% discount rate: Rs.25,00,000 4% growth/ 12% discount rate: Rs.12,50,000 6% growth/ 8% discount rate: Rs.50,00,000 Despite facing these problems we have to keep trying to value a business 31 October

7 Forecasting Process 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the Balance Sheet 5. Forecast the cash flow statement 6. Calculate FCFF or FCFE depending on method used Special emphasis on revenue forecast as all line items are driven directly or indirectly by revenue 31 October

8 Net Present Value methods Free cash flow to equity (FCFE) Free cash flow to firm (FCFF) Gordon Growth Dividend Discount Model: 31 October

9 FCFE Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) - (Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments) Value =FCFE1/(1+k) + FCFE2/(1+k)^2+ FCFE3/(1+k)^3 Used rarely because of changing capital structures of business Used for valuing banks 31 October

10 FCFF FCFF = EBIT (1 - tax rate) + Depreciation - Capital Expenditure Change in non-cash Working Capital Value =FCFF1/(1+WACC) + FCFF2/ (1+WACC)^2+ FCFF3/(1+WACC)^3 Most commonly used cash flow based valuation method Not used for valuing banks 31 October

11 Dividend Discount Model Value =D1/(1+k) + D2/(1+k)^2+ D3/(1+k)^3 Terminal value = Dn+1/(k-g) Expected growth rate = (1- Payout ratio)* Return on equity Used to value mature companies that are expected to grow at the same rate forever. Rarely used but used mostly for mature financials 31 October

12 Relative valuation Example 2: When you plan to buy a new house? How do you value your prospective flat? What has been the built up/ super built up price per sq feet in this area been? Have there been recent sales in the same building? At what prices did they sell? Is the prospective flat comparable? Same logic with valuing companies. Relative valuation Similarly for companies, What business is the company in? How much are companies in similar businesses selling for? Relationship between earnings to price? Is it cheaper or more expensive? Company s growth? Growth comparison with peers. Is it reflected in price? 31 October

13 Ratios used PE, EV/ EBITDA,P/B, P/S, PEG valuation analysis is based on assumption that there is a linear relationship between multiples and fundamentals These fundamentals are Return on capital, expected growth and risks faced by business Usage Cyclical stocks There are times when this method does not work Peak of bull market Market busts 31 October

14 Acquisition value Example 3: If a brokerage cum investment bank wants to acquire a smaller competitor, what will it pay? In a brokerage, you need one CEO, one computer system, one back office dept and one analyst for each sector. So acquired company is worth more to the acquiring company than it would be while operating on its own Acquisition value The value that a company would be to someone else 31 October

15 .. contd Used in M&As Questions that come up while using this method What are the value of cost savings? Who gets benefit of cost savings? Buying company or selling company Despite all the analysis, will management ever want to sell out? These questions need to be answered. We may make good guesses, but not a simple process. 31 October

16 Liquidation value Liquidation value We look at the balance sheet of the company instead of its earning Useful in valuing loss making business, to see if they are available at a bargain Questions that come up while using this method Is the company likely to close down and sell its assets? Because few promoters sell their business 31 October

17 SOP valuation Many companies have multiple lines of business Different businesses are valued by different methods Sum-of-parts-valuation: adding up the results of best guesses and estimates of each business using different methods 31 October

18 Dupont Analysis Dupont Analysis is an expression which breaks ROE (return on equity) into three parts. The name comes from the Dupont Corporation that started using this formula in the 1920s. ROE = (Profit margin)*(asset turnover)*(equity multiplier) ROE = Net Profit / Equity = Net Profit/Sales * Sales/Total Assets * Total Assets/Equity It examines Profitability (measured by profit margin) Operating efficiency (measured by asset turnover), and 31 October Financial leverage (measured by equity multiplier)

19 THANK YOU 31 October