Here are the key points to remember in this chapter

» The valuation models can be classified in two broad categories:

1. Discounted Cash Flow (DCF) valuation model

2. Relative valuation model

» DCF models estimate the intrinsic value of an asset based on the present value of cash flows that an investor expects to receive by holding that asset.

» The measures of cash flow that are typically used are dividend, operating cash flow and free cash flow.

» The simplest type of DCF model is the dividend discount model (DDM).

» Free cash flow to firm (FCFF), which is the cash flow available after all direct costs and investments but before any payments to the capital suppliers.

» Free cash flow to equity (FCFE) is used as the measure of cash flow in the DCF models. This is the cash available after all costs, investments and payments to the debt providers.

» Relative valuation models determine an asset's value relative to that of other similar assets.

» Relative valuation models estimate the value of an equity share as a multiple of certain key variables like earnings, book value, cash flow and sales.

» The P/E ratio is one of the most commonly used tools for equity valuation: It is commonly calculated as given below:

    P/E Ratio = market Price of Equity Share/Earnings Per Share

» P/CF ratio is similar to P/E ratio in all respects except the fact that instead of using EPS in the denominator, we use a cash flow measure.

» The advantage of using cash flow instead of EPS is that cash flow is less susceptible to manipulation.

» P/S ratio has been used widely as it is believed that of all accounting measures, sales are the least susceptible to manipulation.

» DDM is a type of DCF valuation model where only cash flows considered are the dividends actually paid to the investors.

» Using CAPM the cost of equity or required rate of return on equity can be estimated using the following equation:

    Re = Rf + β * (Rm - Rf)

» The Growth rate of earnings of a company can be estimated by the following equation:

    Growth in Earnings = Reinvestment Rate * Return on Equity

        OR

    Reinvestment Rate = Growth in Earnings/Return on Equity

» FCFF can be estimated using the following expression:

    FCFF = PBIT + DEPR - cash Tax - I*T - WCAP - CAPEX

(Where PBIT is the Profit Before Interest and Tax, Cash Tax is the actual tax paid, DEPR refers to depreciation and other non-cash expenses, I*T refers to tax benefit of interest, WCAP refers to the incremental investment in the working capital and CAPEX refers to incremental investment in fixed assets).

» FCFE is the surplus cash available to equity holders after all operating expenses, payment of all liabilities to the debt holders, investment in working capital and capital expenditure.

» FCFE can be estimated using the following expression:

    FCFE = NP + DEPR - WCAP - CAPEX + Net Borrowings

» WACC is the discount rate normally used for discounting FCFF. It can be calculated as follows:

    WACC = We*Re + Wd*Rd (1 - T)

» The cash flows in FCFF approach are independent of capital structure as any tax benefits from using debt have already been deducted from the cash flows.

» FCFE approach is typically used in valuation of banks.

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