Investment Valuation in India

While evaluating differences between accounting line items for Accounting and Valuation purposes, we do come across some Expenses which are treated as Operating Expenses from an Accounting perspective though they are often treated as Capital Expenses for Valuation purposes. Research & Development Expense (R&D) Expense is a common example where it is treated as Operating Expenses under most Accounting Rules (some rules allow Development Expenses to be capitalised with a lot of conditions attached to them), but for valuation purposes they are treated as Capital Expenses because the benefits of R&D are usually derived over a longer period of time. But what about Advertisement Expenses? Companies usually spend a lot of money acquiring customers by spending huge amount of money on Advertisement. Consumer Goods companies such as Unilever, Procter & Gamble (P&G) and beverage companies such as Coke and PepsiCo are known to be heavy spenders on advertisement to get cus...

One of the various methods of valuing businesses, is the Income Capitalisation Method. Income Capitalisation Method assumes that the business will continue in operation even after it is sold. It projects the future income of the business based on historical performance adjusting for estimated changes. Historical financial statements and estimates are used for projecting the future financial statements. Capitalisation rate - The capitalisation rate is the rate of return required to take on operating the business – higher risk leads to higher capitalisation rate. Capitalisation rates are determined based in on the riskiness of the business as well as based on capitalisation rates of comparable companies. Comparable Capitalisation Rate can be calculated as Net income / Market Value. This would give us the capitalisation rate for comparable companies. Net Income / Earnings – The Net Income or the Earnings are used for calculating the Market Value of the company. It is ...

One of the methods of valuing a company based on Discounted Cash Flow Method is as follows: Value of the Company = Free Cash Flow for the Firm (FCFF) for next year / (Cost of Capital - Growth Rate) where: FCFF = EBIT next year x (1 - Tax Rate) x (1 - Reinvestment Rate) Cost of Capital is the Weighted Average Cost of Capital (WACC) i.e. Weight of Debt (Wd) x Cost of Debt (Kd) + Weight of Equity (We) x Cost of Equity (Ke) Reinvestment Rate represents the amount required to be invested in the company every year to keep the company looking good and working well, even if the company does not grow in size. Reinvestment Rate is calculated as Expected Growth rate (g) / Cost of Capital (Kc) Note this is a simplistic method of calculation and is just one of the many ways of calculating value of a company. The method assumes that the company is growing at a constant growth rate which may not be a fair assumption to make, especially in case of start-ups or companies underg...

Growth Investing vs Value Investing                                                          There are a myriad different ways to assess and select stocks and other investment opportunities, two most important strategies are Growth and Value Investing. Growth Investing Growth investing involves picking and investing in stocks that have good growth potential. Usually a growth stock is one whose revenues, cash flows and earnings (profits) are expected to grow at a rate which is higher than the industry or overall market. Growth stocks usually do not pay dividends and concentrate on reinvesting the profits as they expect to generate higher returns. Growth stock investing typically does not put much...

It is nearly impossible to document all ideas, issues, terms and techniques that an investment analysis professional encompasses during his or her work. Analysts often use one or more of the strategies while analysing a potential investment opportunity. Personally I believe that no literature can be complete and authoritative on this subject, though many authors, including myself, have attempted to cover as much as possible. This article only aims at stimulating and imaginative and holistic approach to dealing with investment matters and what questions one should be asking while analysing a company. What is the size of the firm (large, small)? What stage is the company and industry in (new, mature, declining)? Who are the customers of the company (individuals, industry, institutions)? Is the company project oriented (drugs, mining, oil & gas producers, construction)? How is the company socially responsible (is it a source of pollution, land contamination)...

India is in a rising interest rate environment. We have already seen the RBI raising interest rates five times since March 2010. Last week, in its policy review, the central bank left rates unchanged, merely reducing the SLR to 24% from 25%. However, this is certainly not the end of the story. With the inflation showing no signs of easing in the medium term, raising interest rates is one of the most important tools in the hands of the government/central bank. Rising interest rates are generally not taken well by the investors at large. Firstly because it directly hurts the pockets of the individuals. The interest rates are increased to suck money out of the system and to curb the inflation. As rates increase, banks pass on the increase in rates to its customers and consequently home loans become more expensive. People having loans have less disposable income as their monthly payments increase. Let's see how this impacts the businesses. Companies need funds to operate and ...

Gordon Model (Constant Growth rate) The Gordon model assumes a constant growth rate for infinity. The value of the stock is given by: V = D1 / (Re - g) Where, D1 = Expected dividend at the end of the year Re = Required rate of return on equity g = Expected growth rate for a long period of time (mathematically, infinite period) For example, A Ltd. Reported earnings per share (EPS) of Rs 15 last year and paid out 52% of its earnings as dividend. The earnings and dividends are expected to grow at the rate of 8% in the long term as in the past. If the required rate of return on equity shares of A Ltd. is 12%, the value of the security is calculated as follows; EPS = Rs 15 The Current dividend per share is given by the payout ratio times the EPS. Dividend per share (D0) = 15 x 0.52 = Rs. 7.8 So the expected dividend would be given by multiplying the current dividend with the expected growth rate. Dividend per share (D1) = 7.8 x 1.08 = Rs. 8.42 Expected growth rate = 8% Required rate of retu...

The term dividend refers to that part of after-tax profit which is distributed to the owners (shareholders) of the company. The undistributed part of the profit is known as Retained earnings. Higher the dividend payout, lower will be retained earnings. The dividend policy of a company refers to the views and policies of the management with respect of distribution of dividends. The dividend policy of a company should aim at shareholder-wealth maximization. The essence of dividend policy is: If the company is confident of generating more than market returns then only it should retain higher profits and pay less as dividends (or pay no dividends at all), as the shareholders can expect higher share prices based on higher RoI of the company. However, if the company is not confident of generating more than market returns, it should pay out more dividends (or 100% dividends). This is done for two reasons. One, the shareholders prefer early receipt of cash (liquidity preference theory) and sec...

The Black and Scholes Model : The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences. The M...

Nothing is going good for the economy (whether India or the world). The markets are down and no one knows where it is heading. But there is one common view. The markets have bottomed out and there is little downside from here. However, no one knows when is it going to revive. The levels of 21000 seems fantasy at this point. Analysts are jobless and are considered a liability to the erstwhile employers who used to flaunt a research division not more than 4 months ago. But it is said that if there is anything that comes for free in India, it is advise. So here I am, giving free advise. I know I wont be paid foir it anyways ;-) Seven ways to tackle the bear run Stick to stocks of large companies Look for debt free companies Search for businesses that are insulated (well, relatively) from the slowdown Look for companies that largely depend on domestic revenues Search for value stocks (generally cash-rich companies) Have an investment horizon for at least 2-3 years In case of mid-cap stocks...

Valuation is a critical part of the merger process. A deal that may be sound from a business standpoint may be unsound from a financial standpoint if the bidder firm pays too much. The purpose of a valuation analysis is to provide a disciplined procedure for arriving at a price. If the buyer offers too little, the target may resist and, since it is in play, seek to interest other bidders. If the price is too high, the premium may never be recovered from postmerger synergies. These general principles are illustrated by the following simple model. ANALYSIS Mergers increase value when the value of the combined firm is greater than the sum of the premerger values of the independent entities. NVI = V BT – ( V B - V T) where NVI = net value increase V B = value of bidder alone V T = value of target alone V BT = value of firms combined A simple example will illustrate. Company B (the bidder) has a current market value of Rs.40mn. Company T (the target) has a current market value of Rs.40mn. ...

Sales are the lifeblood of any company, and getting a reasonable estimate of sales revenue scale and growth is highly critical in any ensuring business planning exercise, such as capital investment decisions, hiring of staff, expansion of business operations and allocation of operating budgets, etc. Hence, forecasting demand for a company’s products and services, and the resulting revenues accrued is probably the most critical step a financial analyst needs to undertake when building a financial model. In order to arrive at a realistic and reasonable revenue forecast for a business, a good financial analyst should conduct a detailed revenue modeling / demand analysis of a company’s products and services, by examining its usage potential and a customer’s willingness and ability to pay. A demand analysis would entail determining current demand and using assumptions for demand build up to predict future demand over the time period of the financial model. There are a number of qualitative ...

When most investors think about the fundamental value of a company, they usually think of the price to earnings ratio. The P/E ratio tells you how much you are paying for each rupee of a company's earnings (profit). It is popular because it's easy to understand, but in some situations it can be misleading and is not a substitute for real fundamental research. Still, it is a useful tool for valuing an individual stock and can also be used to help you form an opinion on the likely future direction of the stock market as a whole. Understanding the Price to Earnings Ratio The P/E ratio is simply a mathematical calculation. It is the current price of one share of stock divided by earnings per share. The first thing to understand about the P/E ratio is that it is designed to value a share of stock, not a company, and stocks are priced per share. The P/E ratio tells you what the market is willing to pay right now for anticipated future earnings, assuming that the earnings remain const...

SEBI has made rules for valuation of securities by Mutual Funds. Lets look at the valuation Equity Securities for now. Mutual funds shall categorise the securities according to the following norms 1. TRADED SECURITIES : When a security (other than Government Securities) is not traded on any stock exchange on a particular valuation day, the value at which it was traded on the selected stock exchange or any other stock exchange, as the case may be, on the earliest previous day may be used provided such date is not more than thirty days prior to valuation date. 2. THINLY TRADED SECURITIES : (i) Thinly Traded Equity/Equity Related Securities : When trading in an equity/equity related security (such as convertible debentures, equity warrants, etc.) in a month is less than Rs. 5 lacs or the total volume is less than 50,000 shares, it shall be considered as a thinly traded security and valued accordingly. Where a stock exchange identifies the "thinly traded" securities by applyi...

A good financial modeler has the discipline of adhering to a list of guiding principles to help ensure that the development of the financial model achieves the desired results. By following these simple steps, a financial modeler should be able to build a financial model that is simple, accurate and most importantly consistent, to help build confidence in a financial decision making process. Financial Modeling Discipline can be acquired in all 3 stages of the financial modeling process: Specification Stage Design Stage Build Stage Specification Stage Be very clear on the effort involved and the dependencies before committing to deadlines - the financial modeling exercise is usually on the critical path! Get the algebra right — make sure all revenues, cash flow inwards and assets are positive while expenses, cash outflows and liabilities are negative. This will ensure that we rarely use the minus sign in formulae and can use the sum() function. Avoid all calculations that will cause cir...

A good financial modeler should also be aware that besides the most commonly used Discounted Cash Flow (DCF) approach and Market Multiples approach, there are a number of alternative financial valuation techniques that can be used to provide different viewpoints in a financial modeling and valuation exercise. Alternative valuation techniques, when used in combination with the DCF or Market Multiples approach, allow investors or business owners form a holistic view through multiple perspectives on the value of the business under consideration. Alternative valuation concepts include Asset Replacement Cost and Control Premium. Asset Replacement Cost Assessing the adjusted cost of replacing the useful assets of a business is a useful way of valuing capital intensive businesses such as those in the infrastructure and industrial related sectors. Control Premium The term “Control Premium” refers the the extra that typically must be paid to gain operating control of the business. An acquirer w...

Security Analysis Security analysis is about valuing the assets, debt, warrants, and equity of companies from the perspective of outside investors using publicly available information. The security analyst must have a thorough understanding of financial statements, which are an important source of this information. As such, the ability to value equity securities requires cross-disciplinary knowledge in both finance and financial accounting. While there is much overlap between the analytical tools used in security analysis and those used in corporate finance,security analysis tends to take the perspective of potential investors, whereas corporate finance tends to takean inside perspective such as that of a corporate financial manager. Equity Value and Enterprise Value The equity value of a firm is simply its market capitalization; that is, the market price per share multiplied by the number of outstanding shares. The enterprise value, also referred to as the firm value, is the equity va...

Price/sales ratio Price-to-sales ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company's market cap by the company's revenue in the most recent fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-share revenue. The metric can be used to determine the value of a stock relative to its past performance. It may also be used to determine relative valuation of a sector or the market as a whole. PSRs vary greatly from sector to sector, so they are most useful in comparing similar stocks within a sector or sub-sector. Also, since sales are less easy to manipulate as compared to earnings, price-sales ratios are more indicative of performance as compared to price-earnings ratios.

Capital asset pricing model The Security Market Line , seen here in a graph, describes a relation between the beta and the asset's expected rate of return. An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The model was introduced by Jack Treynor, William Sharpe, John Lintner and...