Business Valuation and its benefits

A business valuation will provide you with an accurate estimate of your company's value in the current market. This is a requirement for mergers and acquisition, while also being a great way to strategize for future business succession planning.

Business valuation is as important to your business as to your body is your regular health check-ups. Valuation of your business not only keeps you up-to-date with the health of your business but also keeps you ready for many opportunities that you may come across and miss if you’re not aware about the value of your business.

So, if you’re looking for the reason why you should get the valuation of your business done or what are the benefits that you can get if you already know the value of your business, you’re at the right place. Here are the few of very important benefits of business valuation:

1. Greater Knowledge of Company Assets
Business valuation helps you in knowing accurate value of the assets that your business owns which in turn helps you in obtaining insurance covers and know how much you need to reinvest which further makes your financial planning easier and much more cost effective.

2. Broader Understanding of Company Resale Value
Overall valuation of your business also helps you know the resale value of your company which further helps you in negotiating better while you sell your business. If you’re planning to sell your business in the coming future, the regular valuation of the business will definitely help you in increasing the resale value of the company.

3. Higher Bargaining Power During Mergers/Acquisitions
When you know the value of your company, you won’t let the biggies acquire your company for less than what its worth. And while merging with others you’ll know what percentage of share you need to ask for. Without knowing the value of your company you might end up agreeing to a bad deal. Regular valuation helps you keep track of growth during previous years and also the worth of your company which certainly ensures you that good deals don’t slip off your hands and bad deals don’t fall in your bag.

4. Exposes the business to more investors
When seeking for investment, it is always good to have some accurate data to prove your points. While you’re trying to convince your potential investors to invest, the accurate figures may convince more than your words. Regular valuation helps the investors to understand the worth of your company and also the potential growth in future. Also it is easier to gain the attention of more investors when they can see that investing in your company will be a good decision.

Business valuation is not just about the accurate numbers. Those accurate numbers may help you in knowing the potential future growth, worth of the company and even help you in gaining access to more potential investors. So, do not forget to know the worth of your businesses because only when you know where you are, you can reach where you want to be.

How do the oil prices affect the Rupee – Dollar exchange rate?

At the beginning of 2008 the Rupee rate went as high as 39 to a Dollar and at that time it didn’t look like it will be back to 43 so soon. Economists and Analysts were heralding this as a new era and were asking everyone to reconcile to the new realities of the market.

Just a few months down the line everything has changed. While there are many reasons that pushed the Rupee to 43 levels, perhaps the most unexpected was that oil prices went up to $143 a barrel.

India imports 70% of its oil needs and when the price of oil doubles, it makes a big dent on the country’s fiscal balances. The current account deficit has almost doubled from 2007 in terms of value, and has reached 1.5% of GDP, up from 1% of GDP last year.

Basically that means that to continue to fund India’s imports, the country needs to keep buying dollars and by doing that the value of the Dollar goes up while the value of the Rupee goes down.

High oil prices also mean that the oil companies need to buy Dollars in order to get hold of the expensive oil and further push down the Rupee value. In absolute terms every 10 dollar increase in the price of an oil barrel increases the current account deficit by roughly $6.5 billion dollars and this has to be funded by more dollars.

The RBI has sufficient dollar reserves to ease the pressure off the rupee decline, but the high levels of inflation do not allow it to buy off dollars in the open market as freely as it used to do earlier.

All these factors play out together and push the rupee value down, which is good for exporters but not so good for oil prices and the trade deficit.

What is an APR?

APR or Annual Percentage Rate is the total cost of the debt that you will have to pay annually. The difference between the APR and the interest rate that your credit card company charges you is that APR will also include other costs like annual fee, registration fee etc.

That is why the APR will be always higher than the interest rate that is being advertised. The US and UK law requires lenders to always publish the APR so that it helps consumers to make a fair comparison between two products. This is not possible just by looking at the rate of interest or the other fees alone.

Despite various efforts by regulators, there is no standard on what costs are included as part of APR and what costs do not form part of APR. And therefore it can be a bit in accurate to compare the APRs given by two companies. This link has got some good examples of the things generally covered, mostly covered and never covered.

One last thing to keep in mind is that while APR stands for Annual Percentage Rate it is most of the times simply monthly rate and not the annual rate. While the difference in the monthly and annual rates can be nominal, stretched over a period of 20 – 30 years it may make a significant difference.

Growth Investing

Growth investing is the name given to the kind of investment where the investor buys a stock because the company is in a high growth industry. Such companies are expected to grow at a high rate for the next few years and are generally characterized by a high P/E multiple.

This type of investing became popular in the dotcom era. After the dotcom burst though growth investing ceased to be as sexy as before, but the concept is still widely used by analysts. Typically investments in emerging markets, technology stocks and smaller companies are used as vehicles for growth investing.

What investors need to keep in mind is that the P/E multiple is a means to judge the "price" of a stock and by definition most of the "growth stocks" have high earnings multiples.

Therefore the risk on your investment also becomes that much more. However that doesn't mean that the stocks with high P/E will always be lemons. A lot of investors have made good money on stocks like Apple and Google which typically trade at a higher P/E due to their growth rates. What it means is that if a company doesn't shine as it was promised to; the fall could be quite steep.  

Value at Risk

 Most lenders including financial institutions use the value at risk assessment to determine how much risk is involved in a given scenario. Since they are in business to make money, they have to reduce the amount of risk they involve themselves in. Losing money due to people not paying what is owed can result in them going under as well. With the value of risk they can assess the probability of loss that could occur over a given frame of time.

It is commonly referred to as the VaR by many institutions. There are many factors that play into it, so the results can be quite different from one time period to the next. How volatile the market is at a given time will play a huge role in the VaR. There are several different tools that institutions use to calculate the VaR, but all of them will give them similar results.

However, the VaR also gets plenty of criticism in the market. Many complain that such predictions aren't always a fair indicator of how they will repay what they borrow. Therefore they feel they are being penalized for what has taken place in history rather than based on their own merit.

Reinvestment Risk Rate

There is often a significant risk involved for the holders of bonds when it comes to reinvesting. It is important to understand that the rate of return is going to be less if the rates drop. This is because that process prevents most investors from successfully being about to invest at the assumed rate.

Investors need to be very careful with this when there is a trend of interest rates continuing to drop. Knowing your reinvestment risk rate will help you to calculate the overall risk that is involved with particular types of investments. The fact that the dividends from the initial investment may not be invested at the same or a higher rate is something you will have to be prepared for.

The issue of the reinvestment risk rate pertains more to those that engage in long term bonds than short term investments. This is because they may have to be reinvested after rates have dropped from what the purchase price was. This is one of the main calculations that investors look at when they want to predict what their risk is for a given investment.

CAGR – A Parable

‘Hey! I made 3.2% on my investments last week,’ my friend came running to me all jubilant and brimming with pride.

 

‘That’s pretty good,’ I replied.

 

‘Pretty good! The sandwich I had this morning was pretty good. 3.2% in a week means 166.4% in a year. And that’s not even considering the compounding effect. My week was brilliant.’

 

‘That’s a very nice thought,’ I say. ‘However, that’s not how investments work. Or math works for that matter.’

 

‘Huh?’

 

‘Take a step back. How did your portfolio perform in the week before this one?’

 

‘Something like a negative 1%.’

 

‘So shouldn’t your projection for the next 52 weeks take at least the past 2 weeks into consideration? You know they say the best way to predict the future is to look to the past.’

 

‘So you’re saying that in the next year I’ll make only 3.2% - 1% = 2.2% per week? That’s still a pretty good year.’

 

‘That’s not what I’m saying. I’m saying that if you use CAGR to project in time periods ahead, you’re going to end up with very weird answers. CAGR is a tool for averaging the past, not projecting the future. When you have long time periods and you want to understand them, CAGR comes in handy. It tells you your average gain (or loss) every year which will take you to the same result. It’s basically the same concept as IRR, only in reverse.’

 

My friend looked confused. ‘So when mutual fund houses tell us that they made 80% annualized returns this quarter because they made 20% this quarter…’

 

‘They’re thinking you’ll be dumb enough to buy into that crap. Most reputed funds will not present annualized numbers to you unless the return period is over a year. For most major funds and analysts, daily, weekly, monthly, or quarterly returns are not annualized but only the nominal values are presented. If a fund were to present these numbers on a day when the market moved 1%, their monthly returns would be say 30% while the annual returns would be…’

 

‘365%! That’s insane!’

 

‘Precisely.’

Coal India - Graham Analysis

After going through Benjamin Graham’s “The Intelligent Investor” we wanted to try out the principles learnt on a real life company. Benjamin Graham has proposed some preliminary qualitative checks for the company, such as

• There should be a strong brand
• Business should be easy to understand
• Should be a near-monopoly
• Managers are realistic and have achieved past targets
• Belief in organic growth rather than mergers and acquisitions
• Low managerial remuneration and stock options

Coal India Limited seemed like the right company to take for the next stage of analysis. So we took the company through some of Graham’s basic checks

Current Ratio >= 2

Coal India has maintained a current ratio above 2 only in 1 of the last 5 years, and that was 5 years ago! So a poor start. Verdict – FAIL.

Long Term Debt <= Net Current Assets

Debt-Equity Ratio < 0.5

Coal India operates on very low debt levels. The total borrowings of the company stood at Rs. 2 kCr as of 31 Mar 2021. The total cash, cash equivalents and other bank balances stood over Rs. 28 kCr. The NCA were 18 times higher than the LTD. Verdict – PASS.

Again, the debt to equity ratio as of 31 Mar 2021 was at 0.06. Debt is not a problem for Coal India. Verdict – PASS.

PAT > 0 for the last 10 years

Dividend > 0 for last 20 years

Coal India has been consistently profitable for the last 10 years. Verdict – PASS.

Also, the Company has paid dividends for the last 10 years. Verdict – PASS.

3 year average EPS growth should be 33% over last 10 years

Graham does well for not depending on figures for a single year, which may be a rare year. Rather, Graham always asks you to focus on averages across large periods of times. Especially when he asks you to calculate growth. YoY growth is not as important as growth in 3 year or 5 year averages. In the case of Coal India, the 3 year average EPS growth over the last 10 years was 63% (logarithmic growth). Verdict – PASS.

PE Ratio < 15

Graham is mindful that some industries hold a high PE and some have a naturally low PE. However, according to him no industry should have a PE < 15. Coal India has held a PE < 15 for the last 2 years. Before that the PE stood higher for 3 years. Verdict – PASS.

NW <= MV <= 1.5 NW

Graham acknowledges that the market value should be higher than the book value, considering the future value of the operating assets. However, the PB should not be over 1.5 for any company lest they be overpriced. Here, Coal India’s market value is 2.6 times the book value. Verdict – NEUTRAL.

MV >= Net Current Assets

The market cap of Coal India stands at 2.5 times the Net Current Assets. Verdict – PASS.

Finance costs <= (1/5) PBT

Finance costs <= (1/2.9) PAT

The debt and consequently the finance costs of Coal India are low enough to easily pass this test. Verdict – PASS.

RoE > 20% in 10 years average

RoE > 15% every year for last 10 years

The average RoE has been 46% in the last 5 years and higher than 35% every year for the last 5 years. Verdict – PASS.

Promoter holding >= 20%

Government of India, the promoter of Coal India, holds 66% in the company. Verdict – PASS.

ICSR > 2

The interest coverage service ratio stands comfortably at 49 times and has never been less than 26 in the last 5 years. Verdict – PASS.

This is enough to spark an initial interest in Coal India. This is further increased when we look at the average PB ratio of the company for the last 5 years which is much higher than the present PB ratio for the company. That is in a highly optimistic market of early January 2021 where the indices are reaching new peaks every day.

Finally, the total assets of the company are Rs. 150 kCr. The provisions held by the company are of Rs. 60 kCr out of which Rs. 47 kCr consists of “Stripping Activity Adjustment”. This is a non-payable liability and is incurred as an expense over the regular course of business.

This shows that the company operates on a tight working capital but otherwise is technically and financially extremely sound and might be looking at great returns for its investors in the future.

Cost of Capital

The basic principle for weighting equity and debt in cost of capital is that weights should always be market value numbers as opposed to book value numbers. Most companies and Valuers still often use book value weights for estimating cost of capital due to the following specious reasons:

 

1.      Book Value seems more reliable than market value since book values are not as volatile as market value. While this is true, this is only because book value is estimated only every quarter or every year. The fact that something does not move does not make it more reliable.

 

2.      Taking book value is a more conservative approach. However, this reasoning does not withstand any logical scrutiny. Book value weights are usually less conservative than market value weights and it gives a lower cost of capital. Book value weights tend to weigh debt more (not taking in account the improved or existing repayment capacity of the company and weigh equity less (not taking in account the going concern value of the company). The cost of debt is usually lower than cost of equity, thereby giving a lower cost of capital.

 

3.      The return on capital, i.e. the accounting return on capital, is based on book value. While this is true, the cost of capital has no relation with the return on capital. The cost of capital is the cost at which new funding can be raised from the market today. The book value is completely irrelevant when estimating cost of capital.

 

Hence, for computing cost of capital, we need market value of equity and market value of debt.

 

For a publicly traded company, the market value of equity is relatively simple. The market value of equity is simply the market capitalization of the company. The market value of debt is somewhat trickier as many publicly traded companies have debt that is not rated. So most Valuers and analysts use the book value of debt as a proxy for market value of debt while using market value of equity to compute cost of capital. This is highly inconsistent.

 

The market value of debt can be computed very simply. The inputs we require are (i) the book value of debt, (ii) interest expense, (iii) tenure of the debt. Having these 3 parameters, we can compute the present value of the debt by discounting the cashflow to present terms at the cost of debt. This gives the cost of debt for the company. We can make the same calculation for the company’s lease commitments to estimate the total market value of debt for the company. Some Valuers argue the logic behind converting lease commitments into debt. However, in case of businesses like retailers or restaurants, a bulk of debt takes the form of lease commitments. This changes the cost of capital for the company and the value of the operating assets of the company.

 

So when we’re valuing a company, we take the market value of equity, estimate the market value of debt, and now with the cost of equity and cost of debt, we’re in a position to compute the cost of capital.

 

Some people ask whether to use cost of equity or the cost of capital as the hurdle rate or discounting rate. The answer depends on how we compute returns. If returns mean the returns to equity investors, i.e. cashflows leftover after debt payments, then the appropriate discount rate will be the cost of equity. If returns are measured to the entire business, i.e. return on capital using pre-debt earnings, the appropriate hurdle rate is cost of capital. This goes back to the basic principle of discount rates, i.e. the discount rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.

Approaches to Valuation

Before we begin, let us burst a few general myths about Valuation

 

Myth 1: A Valuation is an objective search for “true value”

Truth: All valuations are biased. The only questions are how much and in which direction.

 

Myth 2: A good Valuation provides a precise estimate of value

Truth: There are no precise valuations. In fact, the payoff to valuation is greatest when valuation is least precise.

 

Myth 3: The more quantitative the model, the better the Value

Truth: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Simpler valuation models do much better than complex ones.

 

With that behind us, there are broadly 2 approaches to Valuation of Securities

 

1.      Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.

2.      Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.

 

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon:

 

1.      a perception that markets are inefficient  and make mistakes in assessing value

2.      an assumption about how and when  these inefficiencies will get corrected

 

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

 

Discounted Cash Flow Valuation

 

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. To use discounted cash flow valuation, you need

1.      to estimate the life of the asset

2.      to estimate the cash flows  during the life of the asset

3.      to estimate the discount rate  to apply to these cash flows to get present value

 

Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets. Since DCF valuation, done right, is based upon an asset's fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

 

Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for (1) equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector and (2) equity portfolio managers, who have to be fully (or close to fully) invested in equities

 

This approach is designed for use for assets (firms) that derive their value from their capacity to generate cash flows in the future. It does make your job easier, if the company has a history that can be used in estimating future cash flows. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to "true" value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm.

 

Relative Valuation

 

The value of any asset can be estimated by looking at how the market prices "similar" or 'comparable" assets. The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics). To do a relative valuation, you need

1.      an identical asset, or a group of comparable or similar assets 

2.      a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value)

3.      and if the assets are not perfectly comparable, variables to control for the  differences 

 

Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO) and investing on "momentum" based strategies. With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).

 

A portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts' judgments are right. It is just less overvalued than other securities in the market. Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail. Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

 

This approach is easiest to use when there are a large number of assets comparable to the one being valued, these assets are priced in a market, and there exists some common variable that can be used to standardize the price. This approach tends to work best for investors who have relatively short time horizons, are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.), and can take actions that can take advantage of the relative mispricing; for instance, a hedge fund can buy the under valued and sell the over valued assets.

 

Contingent Claim (Option) Valuation

 Options have several features

1.      They derive their value from an underlying asset, which has value

2.      The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.

3.      They have a fixed life

Any security that shares these features can be valued as an option.

 

Direct Examples of Options

1.      Listed options, which are options on traded assets, that are issued by, listed on and traded on an option exchange.

2.      Warrants, which are call options on traded stocks, that are issued by the company. The proceeds from the warrant issue go to the company, and the warrants are often traded on the market.

3.      Contingent Value Rights, which are put options on traded stocks, that are also issued by the firm. The proceeds from the CVR issue also go to the company

4.      Scores and LEAPs, are long term call options on traded stocks, which are traded on the exchanges.

 

Indirect Examples of Options

1.      Equity in a deeply troubled firm - a firm with negative earnings and high leverage - can be viewed as an option to liquidate that is held by the stockholders of the firm. Viewed as such, it is a call option on the assets of the firm.

2.      The reserves owned by natural resource firms  can be viewed as call options on the underlying resource, since the firm can decide whether and how much of the resource to extract from the reserve,

3.      The patent owned by a firm or an exclusive license  issued to a firm can be viewed as an option on the underlying product (project). The firm owns this option for the duration of the patent.

4.      The rights possessed by a firm to expand an existing investment into new markets or new products.

 

Advantages of Using Option Pricing Models

Option pricing models allow us to value assets that we otherwise would not be able to value. For instance, equity in deeply troubled firms and the stock of a small, bio-technology firm (with no revenues and profits) are difficult to value using discounted cash flow approaches or with multiples. They can be valued using option pricing.

Option pricing models provide us fresh insights into the drivers of value. In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it.

 

Disadvantages of Option Pricing Models

When real options (which includes the natural resource options and the product patents) are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task.

The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you first need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

Finally, there is the danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash flow valuation for a pharmaceutical firm because it has valuable patents would be double counting the patents if he values the patents as options and adds them on to his discounted cash flow value.

Cost of Debt

To get to the cost of debt, we first need to tackle the more fundamental question – what is debt? There’re 3 criteria of debt

1. There must be a contractual commitment to make payments. This is what separates debt from equity. When a company issues shares, the shareholders assume that the company will make dividend payments. Shareholders may even expect the company to pay dividends. But the company is not contractually obligated to make dividend payments. If the company does not make dividend payments, the shareholders can’t sue the company. But when debt is owed, there is a contractual commitment to make principal and interest payments.
   
   
2. The interest paid on debt is tax deductible.
   
   
3. If the company fails on the contractual commitments, management may lose control of the company and shareholders may lose voting rights.

So what are accounts payable, suppliers’ credit, and advance from customers? Are they debt? In the general sense, the items do not qualify as debt because neither has explicit interest expense, “explicit” being the key word here. When a company takes supplier credit, it doesn’t get discount which it would if the payment was made early. So there’s an implicit interest expense. And if a company is willing to analyze its cost of goods sold and tell us how much of those are lost discounts, then we may be able to ascertain the interest expense for those suppliers’ credit. But in absence of that information, it is very difficult to treat such items as debt. So any interest bearing liability, be it short term or long term, only counts as debt.

What of lease obligations? They are contractual commitments and are also tax deductible. If the company fails on lease commitments, it loses control of that leasehold and may even go bankrupt. So it would be wise to take lease commitments as debt as well. It doesn’t matter whether the leases are operational or capital in nature, but all lease commitments are debt.

Now coming to the cost of debt, it is the rate at which a company can borrow money for the long term today. Notice that we are interested only in the long term cost of debt. Why long term? A company may use short term loans to finance its capital needs. However, we wish to ensure that the company makes more than the rolled over cost of debt, not just the cost of debt for the next 6 months. And a long term cost of debt is a good proxy for the rolled over cost. Why today? Because we don’t care about the rate at which the company borrowed money 2 years ago. The cost of debt today is the rate at which the company can borrow money today.

The cost of debt is thus the risk-free rate plus the default spread of the company. No one should be able to borrow at lower than the risk-free rate. And the default spread accounts for the credit risk in the company. Usually, the default spread is directly given by credit rating agencies in terms of default spreads. However, if the rating is not directly available, we can estimate the default spread based on ratings of companies with similar interest coverage ratios and this gives a good idea of what the risk measures of the company are. Alternatively, the long term debt rate for a company assessed by an independent financer in the business of lending may be another good measure of the cost of debt.

Thinking about Cost of Equity

We were recently working on the Valuation of a large listed steel company where we derived the cost of equity for the company as 11.34% where a team member suddenly asked – does this mean the company will earn 11.34% on the investment?

The traditional view of looking at cost of equity (K_e) has been that markets are priced efficiently and calculating K_e from the CAPM model gives an estimate of what investors would expect to make in a company. However, it is only the return an investor can reasonably expect to make in the long run for the company. This comes with the caveats that the stock needs to be correctly priced and CAPM is the right model for it. But this might not be the best way of thinking about K_e.

Here’s another way to look at K_e. 11.34% is the return an investor needs to make on the company to break even. But why does an investor need to make 11.34% when the risk-free rate is much lower. We need to make 11.34% because this is a riskier investment. So if another investor comes and estimates that the company will make 12% or 13% returns on the stock, then this becomes a good investment opportunity. The 11.34% is our benchmark and if the stock performs better, then it is a good investment for us.

From the standpoint of the management of the company, 11.34% becomes the hurdle rate return to make investors break-even, not exceed expectations. What is the company is unable to achieve this benchmark return? The company will not go bankrupt. But the stock prices will drop and if they drop for a long enough period, perhaps the stock holders will get angry enough to replace the management. Simultaneously, the expected K_e would also drop to meet more realistic levels. This view of cost of equity truly ties the notion that the company belongs to its stockholders and not its management.

Buffet Indicator

The Buffet Indicator (BI) is an approach which hinges on the assumption that the stock market is the barometer of the economy. Holding this assumption to be true, we can assume that in the long run, the markets should only rise (or fall) as much as the economic activity in any nation. How true is that? Let’s find out.

Before we analyze the Buffet Indicator, let us first understand WHAT it is. The Buffet Indicator is simply the ratio of the prominent market index of the economy (such as NIFTY, SENSEX, NIFTY 500, Dow Jones, Hang Seng, NASDAQ etc.) and the GDP of the country. While the market index is a fairly simple number daily updated on the stock exchange, the GDP is a little more tricky.

 

The most widely published numbers for GDP in any economy are the GDP growth rate reported on a quarterly and annual basis with YoY growth (or decline) in constant currency terms. This immediately poses 4 problems

1. GDP is not reported as a number but as a growth rate
2. Which GDP to take? GDP or GDP per capita or GDP (PPP) or some other variant of economic activity
3. The growth rate is not in terms of the immediately preceding quarter but the quarter in the year before
4. The GDP indicator is in real terms while the market index is in nominal terms

The first two problems can be resolved fairly easily. Along with the GDP growth rate, the GDP can also be easily found with some searching. However, we prefer a method wherein we take any arbitrary number for GDP at a certain point in time, and taking the growth rates from there. This is very similar to NIFTY being initiated at a value of 1,000 on 22 Apr 2016. As we’re only interested in the Market-to-GDP ratio, the initial figures are meaningless and we’re only interested in the ratio. In fact, we can use the growth rate of any indicator of economic activity and use the ratio against it. If GDP seems to be an unfair method, we can use any other measure like total funding by banks or total exports by a country or total number of internet users in a country. But by far, we find GDP to be the truest measure of economic activity in a country.

 

The third problem can be tackled by adjusting the GDP growth rate for the annual figures published by the Government or any authentic source such as the World Bank. Another way to approach the problem would involve some mathematical working to take YoY growth figures for every quarter for the market values. We prefer the former method of working.

 

The fourth problem can be dealt in two ways. We can either add the inflation figures to the GDP growth rate, or we can choose to find and use the nominal GDP growth rates. Less prudent investors may still choose a third approach – ignoring inflation. This holds true for an economy where the inflation is static. However, inflation has been very volatile in the past in India. Still, taking a value of inflation opens another pandora’s box which is beyond the scope of this article. For the purposes of this article, we have ignored inflation and assumed the inflation to be consistent in the long run.

 

BI assumes that the measure of economic activity taken is consistent in the long run. However, every decade or so there are fundamental changes in the way GDP is calculated and reported. While one Government may want to highlight nominal GDP figures, another may choose to focus on GDP per capita and the news reports will follow. Consistency is key in long term valuation studies. Another assumption taken by the BI is that the market is a meaningful measure of economic activity and while the same may not seem to be true looking at everyday variations in the stock market, the same does hold true in the long run as evidenced from the graph below.

As seen in the graph, the 5 year average of the Buffet Indicator is a fairly stagnant ratio. Assuming there are no big variations in the GDP growth rate in the short-term, we can assume most of the variation in the Buffet Indicator is attributable to the variation in the market. The assumption is confirmed by the fact that the Buffet Indicator moves in tandem with the market. Whenever a big difference with the average arises, the market sees a sharp movement in the opposite direction (but don’t hold us to this). At the time of writing this article, the CY 2020 Q2 GDP figures have recently been published and the Buffet Indicator is 9% higher than its 5 year average. Are we looking at a sharp correction soon?

A Note on Nominal & Real Cash-Flows

A problem most people face while dealing with valuations is the adjustment in inflation. Inflation being a volatile number in India, most valuers tend to ignore it. In usual practice we see valuers using nominal interest rates and real cash flows without adjusting for inflation at all. This assumption holds true when prices are very inelastic and inflation is zero. However, most products do not follow this rule.

 

So before we delve into what is the correct way to value cashflows, let us first understand the culprits in the situation – nominal & real interest rates and nominal & real cash flows.

 

Nominal interest rates are interest rates quoted by the agency. For example, if the Indian Government is issuing 3.15% T-Bills on 19 Aug 2020, then the nominal rate of interest offered by the Indian Government on those T-Bills is 3.15%. The Real Interest Rate is given by

 

Real Interest Rate = Nominal Interest Rate – Inflation

 

We will get back to inflation in a moment. Regarding cash flows, the basic model remains as

 

Revenue = Capacity * Capacity Utilization * Sale Price

Or Revenue = Past Revenue * Growth

 

Without really caring about where this growth is coming from. As long as the growth is consistent with the past growth, we are comfortable with our valuation. However, it is very imperative to know whether the growth is a result of increase in sale prices, or increase in scale of operations, or the more likely scenario – both! If the growth is on account of increase in sale prices only, then it is not a “real” growth but only in nominal terms. However, if we do not consider the growth in sale prices, then it would be unfair to discount the cash flows at nominal interest rates.

 

The principle that emerges is – Real Cash-Flows must be discounted at Real Interest Rates and Nominal Cash-Flows must be discounted at Nominal Interest Rates.

 

Let’s say we have a cash-flow where we’re using nominal rates. The discount rate is the same as quoted by the market in terms of nominal rates of risk free rates and market premiums. Whereas the cash-flows are being increased in accordance with inflation year-on-year. If we were to convert the same cash-flow to real rates, we would have to reduce the discount rates by inflation and the increase in cash-flows would be reduced to the extent of inflation. The net value of the cash-flows should remain the same. Which makes sense as there should be no effect of inflation on the Valuation Date. It should only affect future cash-flows which are being valued in the discounting model.

 

Next we address the elephant in the room. What should be the inflation rate. Take 10 different sources and they will all give you a different rate of inflation. Broadly, there’re two major measures of inflation – the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). In the long run, both these rates have displayed similar characteristics. Some might even take the long-term increase in gold-prices to be a measure of inflation. However, all these measures are backward-looking and discounting of cash-flows has to be done on a forward-looking basis. The issue remains unresolved at the moment and the closest estimate often taken is a 4% inflation rate given the RBI’s present inflation target.

 

Even as the issue for the measure of inflation remains unresolved, it is prudent to be aware that the discounting of cash-flows must be consistent with the interest rates taken. Otherwise we remain unaware of our own shortcomings while estimating valuations under the discounted cash-flow approach.

Equity Value per Share

When we value a business using FCFF or FCFE, we are able to calculate the value of operating assets generating cash flows. We need to go several steps further to arrive at the value of equity per share. Some of such steps are adjustments for cash and cross holdings. We might want to simply add them to our arrived valuation and let that be. However, this isn’t appropriate in all circumstances. Next, we need to subtract the debt (in case of FCFF) to arrive at the value of equity. This value of equity has two classes of claimholders. Managers and investors may have claim on the company if they’ve been given options. These options need to be netted out before we can arrive at the value per share.

 

Consider a company which earns a return on capital (RoC) just its cost of capital (CoC). It does not create value for the shareholders, but neither does it destroy any value. For companies such as this, cash is a neutral asset. The value of cash on its books can be called as the fair value of the cash. Taking the argument further, consider a company that does not earn its CoC. This means this company has made some bad investments. Cash in the books of a company by itself does not hurt an investor. What does hurt the investor is what the managers do with that cash. If a company is unable to earn its CoC, then the cash will be wasted with the company. In such a scenario, the investor must discount the cash. The management of such a business wastes cash rather than pay it out to the investors as dividend. Conversely, if a company earns more than its CoC, the cash on its books should be valued at a premium. But that is only applicable if the company does not have adequate access to capital markets. With access to capital markets, there’s no need for a company to retain large cash balances. So a premium to cash may be appropriate for emerging market companies, but not for those in developed markets. Further, during times of volatility for such companies, they can use the cash to survive till the economy picks up again, as well as use it to acquire assets from other companies not faring well in the economic downturn.

 

The second point of contention are cross holdings as there’s no reliable mechanism of accounting for cross-holdings. To estimate cross-holdings effectively, we need to know how they’re accounted for in the financial statements. Often they’re valued at book values. In a perfect world, we’d value the parent company on a standalone basis and then value each cross-holding separately. This allows us to treat each company with its own cash flows, growth, and risk rather than apply one CoC and growth rate across the board. However, to do this we need the full financials of each cross-holding company, which is often tough to come by. So there’re 2 compromise solutions. (a) If the cross-holding is in a public traded company, we already have a market price. This is cheating since the idea behind intrinsic valuation is that markets can be wrong and we’re trying to estimate value on our own. But that gets complicated with investments in too many companies. (b) If the cross holdings are in private companies, then we can use the PB ratio from listed companies in the same sector. We use the PB ratio as the record of investment in the cross-holding company is at book value.

 

Next, we need to look at unutilized assets – assets that do not form a part of the operations but are under the ownership of the company. We can either count the value of the cash flows from the asset or the value of the asset, but not both. That’s double counting. Unutilized assets are those who do not contribute to the cash flows in our FCF models. We prepare a collection of such assets and estimate a market value for them. Sometimes companies have real-estate holdings worth more than the rent they generate. So we can have an option to either value the company as a going concern based on its cash flows or we can value it as a collection of real estate holdings, but we can’t add the two up.

 

Last stop is the equity options to the management or investors. The companies that give a lot of options to their employees tend to be young high-growth risky companies. Long term options on risky companies may be valuable pieces of equity. Often, analysts value options based on exercise value, i.e. what is the option worth if it were exercised as on the valuation date. Sometimes they dilute the number of shares to value the options. That undermines how much equity gets given away as such values can be low even for options with significant economic value. So such claims should be valued as options in an option-pricing model. This is the value that needs to be subtracted from the value of the equity to arrive at the value of equity per share outstanding. Similar mechanism may be used for future option values. Companies use options to compensate employees. Since we treat the rest of the compensation as operating expenses, we must treat options in the same light. If we issued these options to the market and used the cash to pay the employees, it’d be cash compensation. So equity options are compensation. Future options are just such compensation exercised in the future.

 

In summary, getting from the value of the operating assets to value of equity per share can be problematic because people try to take shortcuts. If we don’t take shortcuts and work one step at a time, there’s nothing intensely difficult about this process.

Pricing Jet

Aviation in a tough industry. Globally we have seen time & again that the industry is prone to bankruptcy. A significant amount of capital expenditure is required upfront & then there are very high fixed costs. This means that unless we get a high degree of customer stickiness, it becomes very difficult to make a profit. This is a factor we’ve seen play out in India where a lot of airlines have gone bankrupt despite the fact that there is tremendous growth in traffic & the projected growth is also very high. As a result, there’re a lot of airlines investing in growing capacity because they want to cater to this growing market. As they invest in growing capacity they also have to ensure that the capacity gets utilized. That builds a pressure on the airlines to keep pricing at a level where more customers join the band of flyers. This has been a big pain for Indian airlines despite the huge growth margins. India has the lowest airfares in the world[i]. Because the airfares are so low, the airlines are unable to make profits while operating. It is often said that oil is a big factor in aviation but oil has been volatile for over 6 years now. Despite that, the global aviation industry has returned a profit consistently for the last 10 years. It is expected that the industry will hit a profit of $ 36B in 2019[ii]. Looking just at the APAC, the profitability is expected to be $ 10B[iii]. These numbers show that airlines have been on a positive growth trajectory for the last 10 years.

Despite this backdrop, the Jet fallout did happen. The airline industry in India is suffering from very high ATF prices. The tax imposed by the central & state governments on ATF in India make it a very expensive fuel in comparison to their international peers. Further, ATF is not a part of the GST. Hence, airlines are unable to take the set-off of the GST that they pay. Also, there’re a lot of congestions are airports which adds to the operating costs of airlines. Apart from the infrastructure issues, there’s a pursuit for growth & market share resulting in lack of discipline in pricing.

In a distressed situation, the first question asked during valuation is the possibility of a turnaround, i.e. the steps to be taken to make sure that the airline can operate at margins that are remunerative. There has been a history of turnarounds in the airline industry globally as well as in India. Spicejet was almost grounded about 5 years ago & today is one of the best aviation stocks in the world[iv]. Any incoming investor looks at the possibility of a turnaround when they are evaluating a distressed business & try to figure out what is the best they can do with the business. They would always put a higher degree of risk in to the future cashflows of the company because they’re not sure whether they’ll be able to achieve those projected cashflows. One of the most valued assets for any airline is parking slots, which guides an airline’s ability to land at a certain airport. Jet’s parking slots are only available to it till June. If the airline is not revived till then the slots will be up for auction and then the airline will have no value left. Another factor the investors will look at is the flexibility of the lenders in taking a haircut. The equity value of a business is the total value of the business minus the total debt of the business. If the value of the business is less than the value of the debt, then theoretically there is no value to equity. Then an investor would not bother coming in. The only reason an investor would come in is if the lenders are willing to bring their value down to a reasonable number.

From a lender’s perspective, it’s important for them to maximize their recovery. In order to maximize recovery, tough questions need to be faced. If they invest some more money one may argue that it is putting good money after bad. Another argument is that by making a relatively small investment, the lenders may be able to recover a significantly higher sum later. When this starts to play out, the lenders need to have a lot of comfort with the new investor and their business plan. If the lenders have that confidence, things may work out for the airlines.

It remains to be seen if any new investor will perceive value in the airline. However, as the age old adage goes, at the right price, everything is a good asset.

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[i] https://www.telegraph.co.uk/travel/news/revealed-cheapest-countries-for-flights/

[ii] https://www.travelagentcentral.com/running-your-business/stats-airline-profits-to-hit-35-5-billion-next-year

[iii] https://www.iata.org/pressroom/pr/Pages/2018-12-12-01.aspx

[iv] https://www.livemint.com/Companies/T2BOBSwziSYSnEDPMJ2xEM/The-SpiceJet-turnaround-story-and-how-it-became-worlds-best.html

Relative Valuation

Relative Valuation is an approach where an asset is valued not based on of its fundamentals (cash-flows, growth, and risk) but on the basis of what other people are paying for assets just like it. Hence, it is also called “pricing”. It is the way for how 90% of the valuations are done. Relative Valuation has 3 steps.

1. Finding companies just like the subject company
2. Standardizing prices. We cannot compare price per share because it is an arbitrary number. If the stock were to split, the price per share would halve. So we use a multiple. Dividing price by earnings or by book value, we obtain a standardized price.
3. Controlling for those differences. The target company might still be different from other companies in terms of growth and risk in cash-flows which need to be adjusted for.

 Any relative valuation considers a multiple comprising of a numerator and a denominator. In the numerator, we see one of 3 numbers – market value of equity (market cap), market value of the firm (market cap + market value of debt), or enterprise value (market cap + market value of debt – cash). The numerator always takes some measure of market value. With the denominator, we can divide the market value number by revenue or any of the drivers of revenue. There are several advantages of using revenue, it being a positive number helping us to always being able to calculate the multiple. The drivers of revenue may be number of clients for subscription businesses, and such. We may also use a measure of earnings such as net income or operating income for equity and firm respectively. Similarly, we may use the cash-flows in the denominator, using FCFE or FCFF. We can also use the book value in the denominator, using book value of equity or of the firm. Using a multiple involves a 4-step process.

1.  Defining the multiple. The first check on a multiple is the consistency of its definition, i.e. if the numerator of the multiple is an equity value, the denominator has to be an equity value as well. Same goes for firm / enterprise values. The second check should be on the uniformity of estimation of the multiple. If we are using multiple values of 15 firms, we need to be measuring the same thing. A common multiple used is the price-to-earnings ratio. However, the “earnings” portion of that multiple is an accounting number and we know the same accounting standards may result in different degrees of fidelity to those standards. The PE may use the earnings from the most recent financial year or the trailing twelve months. The earnings could be before or after the extraordinary items. The earnings may be primary, partially diluted, or fully diluted. What analysts use is simply the story they’re trying to sell. Similar problems persist with other widely used ratios such as EV/EBITDA. Accounting numbers pose a threat that companies with conservative estimates of earnings look expensive and aggressive ones look cheap.
   
   
2. Describing the multiple. This is an analysis where we find the basic statistical data like average and standard deviation. Most multiple data is asymmetrical. Most ratios such as PE, EV/EBITDA are positive for healthy companies. So the minimum is pegged to zero. But PE ratios may be as high as 100 or even 300 for some companies due to which the averages get pulled out by large positive outliers. Hence the median makes more sense while talking about a multiple. Also, when such ratios are negative, we need to drop the companies from our data-set. As of 30 Nov 2018, 21% of Indian listed companies had a negative PE ratio. That’s losing a lot of data. Also, we are creating a bias in the sample by ignoring the smallest, riskiest, and most troubled companies.
   
   
3. Drivers of multiple. The questions we’re trying to answer here are (a) what are the variables that determine this multiple and (b) how does the change in those variables change the multiple. Again taking PE ratios as an example. We know that high growth companies have high PE ratios. So what is the change in PE for a 1% change in growth? If we can’t answer this question, then we cannot scale our multiples for our specific companies. The simplest way to do that is to use a stable growth dividend discount model for determining the price, and then substitute the mathematical term for the price in the relative valuation multiple.
   
   
4. Apply the multiple. To apply the multiple we need to find out the comparable companies. The lazy way of doing this is to compare companies in the same sector. Reliance is a refinery but is there any refinery company that is remotely close to Reliance? From a valuation perspective, a comparable company is one with similar cash flows, similar growth, and similar growth. There is no need to consider a sector. However, no matter how careful are, there will be differences between the target company and sample companies. We need to find creative ways of controlling for those differences. For example, since high growth companies have high growth rates, we may divide the PE ratio by the growth rate which is called the PEG ratio.

 So one needs to be creative about Relative Valuation. Don’t just compare multiples with the average for the sector. We need to consider the data, look across the sector, and not throw away information. Some statistical analysis enables us to make better judgments about why differences in companies translate into differences in multiples. If we’re able to do that, multiples are excellent tools to have in the arsenal.