Discounted Cash Flow Method

Other methods
 DCF Methods
There are many methods to value a
company or its equity:
1. Enterprise DCF Method
2. Equity DCF Method
3. Adjusted Present Value Method
4. Economic Profit Method
 Equity DCF Method
Dividend Discount Model
Zero Growth Model
Constant Growth Model
Two stage Growth Model
H Model
Three stage Growth Model
 Equity DCF Method
Free Cash Flow to Equity (FCFE) Model
FCFE is the cash flow left for equity
shareholders after the firm has covered all
its CAPEX and WCEX, and met all its
obligations toward lenders and preference
shareholders.
 Adjusted Present Value Method
APV defines value of enterprise as the sum of two
components;

Value of the Enterprise = Value of the unlevered

EFCF + value of the interest tax shields
 Economic Profit Method

EP = OIC (ROIC – WACC)

 Equity DCF Method
Dividend Discount Model: Zero Growth Model
ZGM assumes that the dividend per share remains
constant year after year at a value of D. So,
Po = D
r
Where
Po is the price of equity share
D is dividend expected in a year
r is required rate of return
 Equity DCF Method
Constant Growth Model
This model assumes that the dividend per share grows
at a constant rate (g). The value of the share will be;
Po = D1
r–g
Where
Po is the price of equity share
D1 is dividend expected in a year
r is required rate of return
 Equity DCF Method
Constant Growth Model
What does drive the growth?
1. Plough back ratio
2. ROE
For Instance; Omega Ltd has net worth (Equity) of
100 at the beginning. ROE is 20%. Pay out ratio is
40 %. Plough back ratio is 60%.
Growth = Plough back ratio X ROE
0.6 X .20 = 0.12 or 12%
Financials of Omega Ltd for 3 years will be
Equity DCF Method
 Equity DCF Method
Two stage Model
This model is an extension of the constant growth
model. It assumes that the extraordinary growth
(Good or Bad) will continue for a finite period and
thereafter, normal growth rate will prevail
indefinitely.
Equity DCF Method
 Equity DCF Method
Two stage Model – H Model
H Model is also a two stage model. Unlike the
classic two stage model, H model, developed by
Fuller and Hsia, assumes that the earnings growth
rate begins at a high in initial rate (ga) and declines
at a linear rate over a period of 2H period to a
stable growth rate (gn) which is maintained for
ever. This method assumes that cost of equity and
dividend payout rate remain constant and they are
not influenced by the changing growth rates.
Equity DCF Method
 Equity DCF Method
H Model
 Equity DCF Method
Three Stage Model
Three stage model is a combination of Two stage
model and H Model. Three stage model assumes
that an initial period of stable growth, a second
period of linearly declining growth period, and a
third period of stable low growth that extends for
ever. The value of share as per this model is;
Equity DCF Method
 FCFE Model

Free Cash Flow to Equity (FCFE) Model

FCFE is the cash flow left for equity shareholders
after the firm has covered all its CAPEX and
WCEX, and met all its obligations toward lenders
and preference shareholders.
 FCFE Model

FCFE = (PAT- Pref.Div) - (CAPEX - Dep) -

(Change in net working capital) + (New debt -Debt
repayment) + (NPC -PC repayment) - (Change in
investment in marketable securities)
 FCFE Model

Value of equity = FCFE1/ (1+r)1 + FCFE2/ (1+r)2 +

FCFE3/ (1+r)3 + FCFE4/ (1+r)4 + FCFE5/ (1+r)5 +
(FCFE5/r-g) X (1/(1+r)5)
 Relative valuation

In DCF, an asset is valued on the basis of its cash flow,

growth and risk characteristics.
In Relative valuation, an asset is valued on the basis of
how similar assets are valued.
Dan Ariely said that “Everything is relative even when it
should not be”.
Instance: Real Estate, Marks
In common sense and economic logic, similar assets
should sell at similar price
Relative valuation is not a substitute for DCF, but it is a
complementary
 Relative valuation

Steps involved
1. Analyze the subject company
2. Select comparable company
3. Choose the valuation multiples
4. Calculate the valuation multiples for comparable
company
5. Value the subject company
 Relative valuation

1. Analyze the subject company

Subject company’s competitive and financial position are to be
analyzed. Key aspects to be considered in this analysis include;
1. Product portfolio and market
2. Cost of inputs
3. Production and technological capacity
4. Market image,
5. Managerial competence
6. Quality of HR
7. Competitive dynamics
8. Financial aspects
 Relative valuation

2. Select comparable companies

Initially select 10 to 15 companies
Narrow down to 3 to 4 companies
Finding a right comparable company is a
challenging one
 Relative valuation

3. Choose valuation multiples

A number of valuation multiples are there. Prominent
valuation multiples include;
Equity valuation multiples – PE ratio, P to BV ratio,
Price to sales ratio
Enterprise valuation multiples – EV-EBITDA ratio, EV-
FCFF ratio, EV to Book value ratio, EV to Sales ratio
4. Calculate the valuation multiples for comparable
company
5. Value the subject company
 Equity valuation multiples

Commonly used equity valuation multiples are

1. Price to Earnings (P/E) multiple
2. Price to Book value multiple
3. Price to sales multiple
 Price to Earnings multiple

Price to Earnings (P/E) multiple

= MPS/EPS or Po/Et
Fundamental determinants of P/E multiple

Po/Et = 1-b
r – ROE X b
Where 1-b is dividend payout ratio
r is cost of equity
b is ploughback ratio
ROE is return on equity
 Price to Book value multiple

Price to Book value (P/B) multiple

= Shareholder’s fund – Preference capital/ No of
outstanding equity shares
Fundamental determinants of P/B multiple
P/B = ROE(1-b)/r-g
Where
g is growth rate
r is the expected rate of return
1-b is dividend payout
 Price to Sales multiple

Price to sales (P/S) multiple

= MPS/RPS or MPS/Annual sales of the company
Fundamental determinants of P/S multiple
P/S = NPM(1+g)(1-b)/r-g
Where
NPM is Net profit Margin ratio
g is growth rate
r is the expected rate of return
1-b is dividend payout
 Enterprise Valuation Multiples

Equity multiples focus on value of equity while

enterprise value multiples focus on the value of
enterprise. The commonly used enterprise value
multiples are;
EV/EBITDA multiple
EV/EBIT multiple
EV/FCFF multiple
EV/BV multiple
EV/Sales multiple
 EV/EBITDA multiple

EV/EBITDA multiple
= EV/EBITDA
Fundamental point of view
EV/EBITDA = ROIC –g X (1-DA) (1 – t)
ROIC (WACC-g)
 EV/EBIT multiple

EV/EBIT multiple
= EV/EBIT
Fundamental point of view
EV/EBIT = (1 – t) (1 – reinvestment rate)
WACC-g
 EV/FCFF multiple

EV/FCFF multiple
= EV/FCFF
Fundamental point of view
EV/FCFF= 1
WACC-g
 EV/BV multiple

EV/BV multiple
= EV/BV
Fundamental point of view
EV/BV= ROIC -g
WACC-g
 EV/Sales multiple

EV/Sales multiple
= EV/Sales
Fundamental point of view
EV/Sales= After tax operating margin (1+g) (1 –
reinvestment rate)
WACC-g
 Choice of Multiples

Different multiples provide different values. So, choice

of multiple makes difference to value estimate.
Which multiple is to be chosen?
According to Aswath Damodharan
One can adopt the multiple that reflects the biases (the
cynical view) or
Use all the multiples (the bludgeon view) or
Pick the best multiple
 The cynical view

In cynical view, one can choose a multiple that serves a

preconceived notion. Suppose, if you want to sell a
business, choose the multiple that gives the highest
value. On the other hand, if you want to buy a business,
choose the multiple that gives the lowest value. This
method may look like manipulation and not a analysis,
but it is a common method.
 The Bludgeon view

In this method, one can use various multiples to value a

company. But, a multiple that is accepted by all will be
chosen.
 The best multiple

Choosing the best method. There are three ways to find

the best multiple.
Fundamental approach: Correlation between current
earnings and value of the company
Statistical approach: Regress each variable against the
fundamentals.
The conventional approach: P/E multiple for the
companies that have positive earnings
The EV/Sales for young companies
 The best practices using multiples

Define the multiples consistently

Choose comparables with similar profitability and
growth prospects
Identify the fundamental determinants
Use the multiples that use forward looking estimates
Prefer enterprise value multiples