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Suraj Dubey
Email: surajdubey11@gmail.com
Phone: 9920880152
Introduction - Concept of Fair Value
Buy Side refers to those institutions that are engaged in buying research conducted by others. They
invest/manage client’s funds (as well as their own) into investments in primary or secondary markets. Primary
Buy Side Institutions market refers to direct investment in companies while secondary involves buying/selling stocks in the stock
market. E.g. - Mutual Funds, Hedge Funds, Private Equity Firms & Venture Capitalists (any Asset Management
Company).
Sell Side is involved with recommending buy/sell decisions to clients. The buyers of such reports may be Retail
clients, High Net-worth Individuals or Institutional investors. E.g. - Brokerage Houses, Research Firms &
Sell Side Institutions focused KPOs.
(Note: Many Investment Banks play both buy/sell side roles)
Corporate Finance refers to managing finances of a company and involves selecting projects, creating budgets
and arranging funds. Their job is the toughest one i.e. Creating Wealth in the secondary market through
Corporate Finance managing expectations and delivering superior results. They use valuation to understand gaps in expectation
and performance of the firm as a whole and to take decisions at a project level.
Valuation Approaches
▪ There is no best method. Apart from the pros/cons, each method is designed to suit: investment horizon, investment type, market
conditions, sector, scenario and so on.
▪ Investment Horizon & Valuation
Investment Horizon i.e. Short Term or Long term investor is typically interested in determining fair value between quarterly results. Although DCF provides an intrinsic
value, in the short run, share prices may be very volatile and DCF will not help such an investor in any way. Hence, short term investors (speculators/traders) must rely
on trends, sentiments and news to determine valuation. These factors are best captured in the Comparables Method (Relative Valuation). On the other hand, long term
investors rely on DCF, as it goes beyond the short term trend and provide true potential of an investment.
The best approach is what many call the ‘Valuation Football Field’. This involves determining fair value using all relevant approaches
followed by drawing an inference in terms of a fair value range. This approach also helps in using one method to ‘sanitize’ the other.
Best Valuation Method: Public vs Private
In short, Transaction Comparables result in highest valuations. While, in Bull markets Comparables result in higher valuations than DCF. The reverse holds
true in Bear markets. Unlike what many believe, DCF does not inflate value or result in highest value. The so called DCF inflation is a result of errors &
unrealistic assumptions as a consequence of oversimplification of the approach.
Best Valuation Method: Business-wise
▪ Start-ups
Startups are driven by far too many factors to be captured by simplistic valuation models. Their sensitivity to economic, sector specific and company specific factors must
be captured as far as possible to reasonably value them. These factors can only be captured with the DCF method.
▪ Matured Companies
Matured Companies have fairly predictable financials and hence DCF will result in a fairly reliable valuation. However, the Dividend Discount Model will also work reliably,
as matured companies have nominal expansion needs and hence a high dividend payout ratio along with predictability of growth rates. E.g. Large FMCG companies.
▪ IPO Valuation
Although for such situations it is best to use DCF as it determines the intrinsic value, not many will want to use it as it is likely to understate value as against Comparable
valuation. Simply because, the idea behind an IPO is to raise maximum possible capital for a minimum dilution in equity. Hence most IPOs come out in bull markets where
valuations are already stretched and Comparable Valuation will result in higher values as compared to DCF. Consequently, one may notice that IPOs are demand driven
rather than intrinsic value led, as a result many average companies get extraordinary valuations.
▪ Cyclical Companies
Cyclical Companies, by virtue, have a very high degree of uncertainty. Secondly, such companies are always on the radar for news & management comment both of which
are immediately reflected in Comparables. On the other hand, DCF may have to wait for a quarter or more to reflect a change. E.g. Sugar companies.
▪ Distressed Companies
Distressed company valuation, is particularly tricky as the challenge lies in finding fair value and not the lowest value. By distressed, we mean loss making companies or
those that are restructuring their businesses by selling off ‘toxic assets’ and toning down capital structure. Traditional valuation approaches fail miserably as a result of the
uncertainty involved and this is where Liquidation Value & Replacement cost method come into the picture. Liquidation Value measures return from selling off or
liquidating the assets while Replacement Cost measures the opportunity cost of setting up a business. E.g. Textile companies.
Best Valuation Method: Sector-wise
▪ Basic materials
Steel & Cement represent basic/building materials. The sectors are cyclical (driven by expansion cycles). Being cyclical, in normal/bullish scenarios, Comparables
approach is best suited. However, in downturns it is better to shift to Asset based approaches to reflect maximum downside potential.
▪ IT & ITes
IT & ITes companies have very complicated business models where revenues are scattered and unpredictable, face constant threat of protectionism and so one simply
cannot have liable long term forecast. Hence Comparables is chosen over DCF by most. However, the use of DCF in very bullish/bearish markets is suggested.
▪ Telecom
The Telecom sector has rich & abundant data availability to generate very reliable numbers over a 3-5 year horizon and the business model can be very easily broken
down into a flow of numbers. For this reason it is recommended to use the DCF approach. However, many analysts use Comparables to provide short term targets.
▪ Healthcare / Hospitality
Like telecom, these sectors too can be very easily broken down into a logical flow of numbers resulting in a reliable medium-long term forecast. Hence DCF is a rational
choice. However, asset based approaches are a must in bearish markets to determine ‘worst case scenario’ valuation.
▪ Core Sectors
Infrastructure, Power and Oil & Gas together form the core sector. These sectors are primarily driven by government policy and funding, the details of which are clearly
made available. Having distinct drivers along with rich data availability make it a perfect DCF candidate. Meanwhile, asset valuation should also be used as a support.
▪ Retail
Although appearing to be simple, this is one of the most complicated sectors to value. The complexity is a result of distant breakevens, multiple formats, complex
funding provisions (debt/lease/cash) and uncertain demand. This leads to a hybrid valuation approach often called SOTP Valuation.
▪ What we use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise Value?
For Unlevered Free Cash Flow, we would use Enterprise Value, but for Levered Free Cash Flow we would use Equity Value.
Remember, Unlevered Free Cash Flow ignores Interest and thus represents money available to all investors, whereas Levered already accounts for Interest and the
money is therefore only available to equity investors. Debt investors have already "been paid" with the interest payments they received.
▪ Why we use unlevered free cash flow (UFCF) vs. Levered free cash flow (LFCF)?
UFCF is the industry norm, because it allows for an apples-to-apples comparison of the Cash flows produced by different companies. A UFCF analysis also affords the
analyst the ability to test out different capital structures to determine how they impact a company’s value. By contrast, in an LFCF analysis, the capital structure is taken
into account in the calculation of the company’s Cash flows. This means that the LFCF analysis will need to be re-run if a different capital structure is assumed.
In effect, UFCF allows the analyst to separate the Cash flows produced by the business from the structure of the ownership and liabilities of the business. In a UFCF the
Cash flows of the business are projected irrespective of the capital structure chosen in a UFCF analysis; the exact capital structure is not taken into account until the
Weighted Average Cost of Capital (WACC) is determined.
General Concepts
▪ Do we always use the median multiple of a set of public company comparables or precedent transactions?
There's no "rule" that we have to do this, but in most cases we do because we want to use values from the middle range of the set. But if the company we are valuing
is distressed, is not performing well, or is at a competitive disadvantage, we might use the 25th percentile or something in the lower range instead - and vice versa if
it's doing well.
▪ Why can't we use Equity Value/EBITDA as a multiple rather than Enterprise Value/EBITDA?
EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to
pair them together.
Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part available to
equity investors.
▪ The EV/EBIT, EV/EBITDA, and P/E multiples all measure a company's profitability. What's the difference between them, and when do you we each one?
P/E depends on the company's capital structure whereas EV/EBIT and EV/EBITDA are capital structure-neutral. Therefore, we use P/E for banks, financial institutions,
and other companies where interest payments / expenses are critical.
EV/EBIT includes Depreciation & Amortization whereas EV/EBITDA excludes it – we are more likely to use EV/EBIT in industries where D&A is large and where capital
expenditures and fixed assets are important (e.g. manufacturing), and EV/EBITDA in industries where fixed assets are less important and where D&A is comparatively
smaller (e.g. Internet companies).
▪ How do we value banks and financial institutions differently from other companies?
We mostly use the same methodologies, except:
We look at P/E and P/BV (Book Value) multiples rather than EV/Revenue, EV/EBITDA, and other "normal" multiples, since banks have unique capital.
We pay more attention to bank-specific metrics like NAV (Net Asset Value) and we might screen companies and precedent transactions based on those instead. Rather
than a DCF, we use a Dividend Discount Model (DDM) which is similar but is based on the present value of the company's dividends rather than its free cash flows.
We need to use these methodologies and multiples because interest is a critical component of a bank's revenue and because debt is part of its business model rather
than just a way to finance acquisitions or expand the business.