Chapter 32

Business Valuation

Approaches/Methods of
Valuation
There are four approaches to valuation of
business (with focus on equity share
valuation):
1)
2)
3)
4)

Assets based
Earnings based
Market value based
Fair value method

Price Earnings (P/E) Ratio

The P/E ratio (also known as the P/E multiple) is the method most widely
used by finance managers, investment analysts and equity shareholders
to arrive at the market price of an equity share. The application of this
method primarily requires the determination of earnings per equity share
(EPS). The EPS is computed as per Equation
EPS = Net earnings available to equity shareholders during the
period/Number of equity shares outstanding during the period.
(5)
The EPS is to be multiplied by the P/E ratio to arrive at the market price of
equity share (MPS).
MPS= EPS P/E ratio

(6)

The P/E ratio may be derived given the MPS and EPS.
P/E ratio = MPS/EPS

(7)

Example
Company has future maintainable profits after taxes as Rs. 78 lakhs
(i) The company has 1,00,000 11% Preference shares of Rs 100 each,
fully paid-up.
(ii) The company has 4,00,000 Equity shares of Rs 100 each, fully paid- up.
(iii) P/E ratio is 8 times.
Solution
Determination of Market Price of Equity Share
Future maintainable profits after taxes
Less: Preference dividends (1,00,000 Rs 11)
Earnings available to equity-holders
Divided by number of equity shares
Earnings per share (Rs 67 lakh/4 lakh)
Multiplied by P/E ratio (times)
Market price per share (Rs 16.75 8)
Value of Business is MPS x no. of outstanding shares

Rs 78,00,000
11,00,000
67,00,000
4,00,000
16.75
8
Rs 134
Rs 536,00,000

Computation of Free-Cash
Flows to the firm
After tax operating earnings (including interest cost)
Plus: Depreciation & Other non-cash items
Less: Investment in long-term assets
Less: Investment in operating net working capital_______________________
Operating free cash flows (OFCF)
Plus: After-tax non-operating income/CF
Plus: Decrease in non-operating assets_______________________________
Free Cash flows to the firm (FCFF)

FCFF to all investors t

t

k
t 1
0

Value of Firm0

Alternatively, the value of equity can be determined directly by discounting

the free cash flows available to equityholders (FCFE) after meeting
interest, preference dividends and principal payments, the discount rate
being ke, that is,

FCFF to equityholders t
Value of Equity 0
1 k e t
t 1

Market Value Based Approach to Valuation

The

market value (reflected in the stock market quotations) is the

most widely used approach to determine the value of a business, in
particular of large listed firms.
The market value indicates the price the investors are willing to pay
for the firms earning potentials and the corresponding risk.
This method is particularly useful in deciding swap ratios in the case
of merger decisions.
Usually, 12 months average of stock prices or the average of high &
low values of stocks during a year can be taken.
Market value per share x no. of outstanding shares = value of
business

Fair Value Method

Fair

value method is not an independent method of share valuation.

The method uses the average/weighted average of two or more of the
above methods.
Therefore, such a method helps in smoothening out wide variations
caused by different methods and indicates the balanced figure of
valuation.

Valuation Relative to Industry

Averages
1. Dividend Yield Method:
Value per share = Co.s dividend per share x Nominal Value of share
Industrys avg. div. per share
Value of business = value per share x no. of o/s shares
2. Earnings yield method:
Value of business = Cos expected future maintainable profits
Industrys normal earnings yield
3. Return on Capital employed:
Value of business = Cos expected future maintainable profits
Industrys normal rate of return on capital employed

Valuation Relative to Industry

Averages
4. Price/Earnings (P/E Ratio) method:
Value of business = Cos expected future maintainable profits x
Industrys average P/E Ratio

Discounted Cash Flow

Valuation Models
1.
2.

3.

4.

Discounted Dividend Model (two-stage growth model)

Discounted Cash-Flow Model (Continuing Value
method)
Discounted IRR Method (Instead of cost of capital
(k), IRR is used to discount the cash flows and
determine the present value
Discounted EVA method

Theoretical Valuation Models

1.
2.
3.
4.

Dividend Growth Model (Gordons Model)

Walters Valuation Model
MMs Dividend Model
CAPM Model (used in determining the
rate of return from equity ke

Valuation based on Cos

fundamentals
1. Revenue or Sales multiple:
Business Value = _ROCE g x (1-T) m
Sales
ROCE x(k-g)
m = profit margin
2. Operating profit multiple:
Business Value = ROCE g x (1-T) (1-D)g
EBIDT
ROCE x(k-g)
3. Operating multiple:
Business Value = ROCE g x NOPAT
Unit
ROCE x(k-g) unit

Valuation based on Cos

fundamentals
4. P/E Multiple:
Market price per share = ROE g__
EPS
ROE x (k-g)
5. Price/Book Value multiple:
Market price per share = ROE g_ x ROE
Book value per share ROE x (k-g)

Market Value Added (MVA)

The market value added (MVA) approach measures the
change in the value of the firm from the perspective of all the
providers of funds (i.e., shareholders as well as
debentureholders).
MVA = [Total market value of the firms securities (Equity
shareholder funds + Preference share capital + Debentures)]
The MVA from the point of view of equity shareholders is =
(Market value of firms equity Equity funds)

Example
Supreme Industries has an equity market capitalisation of Rs 3,400
crore in current year. Assume further that its equity share capital is Rs
2,000 crore and its retained earnings are Rs 600 crore. Determine the
MVA and interpret it.
Solution
MVA = (Rs 3,400 core Rs 2,600 crore) = Rs 800 crore.
The value of Rs 800 crore implies that the management of Supreme
Industries has created wealth/value to the extent of Rs 800 crore for
its equity shareholders.
Well managed companies, having good growth prospects, and
perceived so by the investors, have positive MVA. Investors may be
willing to pay more than the net worth. In contrast, companies
relatively less known or engaged in businesses that do not hold
future growth potentials may have negative MVA.

Example
Hypothetical Limited has equity market capitalisation of Rs 900 crore in
the current year. Its equity share capital and accumulated losses are of
Rs 1,200 crore and Rs 200 crore respectively. Determine the MVA of the
firm.
Solution
MVA = (Rs 900 crore Rs 1,000 crore) = (Rs 100 crore).
The firm has negative MVA of Rs 100 crore. The investors discount its
value/worth, as it is loss incurring firm.
The market value added approach reflects market expectations and is
essentially a future-oriented and forward looking approach. The
investors, willing to pay a different price (other than one suggested by
book value), are guided by the individual companys future prospects,
future growth rates, risk complexion of the firm, industry to which the
firm belongs, required rate of return and so on.

Thank You