Investment Valuation in India

Investment decisions often rely on Cash flows rather than profits. While profits are the key measure of financial success from an accountant’s perspective, finance professionals (especially investment analysts) prefer evaluating investment decisions based on cash flows. One may wonder that while studying Accounting (which is the first step in understanding finance) we were first introduced the concept of Cash Basis of Accounting where all receipts and payments were recorded, then we were told that the right measure of evaluating business performance was through Accrual Accounting. However, we’re again talking about Cash Flows – which is a subset of or is similar to Cash Basis of Accounting. Well, let’s not get into that right now as Life is hard to understand. But the concept of Cash flows is not. Let’s understand how the cash flows and profits are related First, as we have discussed already, Profits are arrived at based on Accrual basis of accounting. Revenues are reco...

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...