Fundamental analysis of stock mini project

RESEARCH

METHODOLOGY

1

OBJECTIVE OF THE STUDY:

Primary :

To do fundamental analysis and calculate intrinsic value of Public Sector

Enterprises which are represented in NIFTY 50. Here PSEs is considered to

be that companies where Government of India is having more than 50% stake

and no other government is taken into consideration.

Secondary :

1. Analyzing historical performance.

2. Estimating growth prospect of various companies.

3. Understanding Discounted Cash Flow model and its usage.

4. To learn about linkages between share values, earnings, and expected

return on capital.

SCOPE:

The analysis is based on main activities i.e. operating activities of the company

and other activities are ignored. Assumptions are based on recent annual reports, past

performance, current trends in that sector and statistics of RBI. We have considered only

PSEs that are represented in NIFTY 50 and our assumptions are limited to those

companies only and not all PSEs or any other companies.

RESEARCH DESIGN:

Research design selected for this project is descriptive.

2

DATA COLLECTION METHOD:

Data for our objective was collected through companies’ website i.e. secondary

data and various other websites to know the current scenario.

TARGET:

Public Sector Enterprises of India representing in NIFTY 50. Here PSEs is those

companies where Government of India is having more than 50% stake and not any other

government.

SAMPLING TECHNIQUE:

Convenience sampling.

SAMPLE SIZE:

6 companies (basically there are 7 companies but we have ignored PowerGrid

from our estimation because just two years have passed for the company going public so

it is difficult to estimate and make assumptions based on it).

BENEFICIARY:

1. Investors in stock market.

2. Students pursuing professional courses like MBA, CFA, CFM and

likewise.

3. Financial Institutions and Mutual Funds.

4. Ministry of Finance for disinvestment policy.

3

LIMITATIONS:

1. Intrinsic values are based on operating income only and no other inflows

are considered.

2. Project is restricted to PSEs representing NIFTY 50 and not all PSEs.

3. No company visits are possible so assumptions are based on secondary

data, current scenario and statistics of RBI.

4

Introduction to

INDIAN EQUITY

MARKET

5

The Indian Equity Market has mainly two indices i.e. NIFTY and SENSEX. The

equity market of India is one of the oldest in the Asia region. India had an active stock

market for about 150 years that played a significant role in developing risk markets as

also promoting enterprise and supporting the growth of various industries. India has been

one of the best performers in the world economy in recent years, but rapidly rising

inflation and the complexities of running the world’s biggest democracy are proving

challenging.

STRUCTURE OF EQUITY MARKET:

The Indian market of equities is transacted on the basis of two major stock

exchanges, National Stock Exchange of India Ltd. (NSE) and The Bombay Stock

Exchange (BSE). In terms of market capitalization, there are over 2500 companies in the

BSE chart list with the Reliance Industries Limited at the top. The SENSEX at present is

ranging between the level of 15000-17000 providing a profitable business to all those

who had been investing in the Indian Equity Market. There are about 23 stock exchanges

in India which regulates the market trends of different stocks.

Generally the bigger companies are listed with the NSE and the BSE, but there is

Over the Counter Exchange of India (OTCEI), which lists the medium and small sized

companies. SEBI is the body who governs and supervises the functioning of the stock

markets in India.

Stock markets became intensely technology and process driven, giving little

scope for manual intervention that has been the source of market abuse in the past.

Electronic trading, digital certification, straight through processing, electronic contract

notes, online broking have emerged as major trends in technology. Risk management

became robust reducing the recurrence of payment defaults. Product expansion took

place in a speedy manner. Stock exchange reforms brought in professional management

separating conflicts of interest between brokers as owners of the exchanges and

traders/dealers.

6

GROWTH OF INDIAN EQUITY MARKET:

The last decade has been exceptionally good for the stock markets in India. In the

back of wide ranging reforms in regulation and market practice as also the growing

participation of foreign institutional investment, stock markets in India have showed

phenomenal growth in the early 1990s. The stock market capitalization in mid-2007 is

nearly the same size as that of the gross domestic product as compared to about 25

percent of the latter in the early 2000s. Investor base continued to grow from domestic

and international markets. The value of share trading witnessed a sharp jump too. Foreign

Institutional Investment in Indian stock markets showed continuous rise reaching about

USD10 billion in each of these years between FY04 to FY06.

Indian equity markets now offer, in addition to trading in equities, opportunities

in trading of derivatives in futures and options in index and stocks. ETFs are showing

gradual growth. Within five years of introduction of derivatives, Indian stock markets

now are ranked first in stock futures and fourth in index futures. Indian stock markets are

transaction intensive and thus rank among the top five markets in this regard.

7

INTRODUCTION

OF COMPANIES

8

The main challenge before any country is to move ahead with rapid expansion as

well as development. This challenge seems to be an opportunity for any government and

they play an important role in any economy to bring its country to the top of the world.

The basis for selecting companies for our project i.e. equity valuation is those

Public Sector Enterprises (PSEs) representing in NIFTY 50. There are total 246 PSEs

(mentioned in Appendix II) which were owned or having majority stake by central

government and out of that 7 companies are in NIFTY 50. Those companies are:

Bharat Heavy Electricals Ltd. (BHEL)

Bharat Petroleum Corporation Ltd. (BPCL)

Gas Authority of India Ltd. (GAIL)

National Thermal Power Corporation Ltd. (NTPC)

Oil and Natural Gas Corporation Ltd. (ONGC)

Power Grid Corporation of India Ltd. (PowerGrid)

Steel Authority of India Ltd. (SAIL)

We have valued six companies out of seven mentioned above. In all that

PowerGrid is not being valued because just two years have passed going public. So we

are unable to predict its future growth prospect based on their two years data as well as

we were unable to assume its revenue growth rate, depreciation, change in working

capital, change in capital expenditure and weighted average cost of capital. This is the

main reason why we go with remaining six companies to go ahead with our project and

all six companies’ snapshots and brief history is mentioned in next page.

9

1. BHEL

BHEL is the largest engineering and manufacturing enterprise in India in the

energy related/infrastructure sector. BHEL was established more than four decades ago

ushering in the indigenous heavy electrical equipment in India. BHEL has built over the

years, a robust domestic market position by becoming the largest supplier of power plant

equipment in India, and by developing strong market presence in select segments of the

Industrial sector and the Railways. Currently, 80% of the Nuclear power generated in the

country is through BHEL sets. For the third consecutive year, BHEL’s performance was

recognized by the prestigious publication “Forbes Asia”, which featured BHEL in its

fourth annual 'Fabulous 50' list of the best of Asia-Pacific's publicly-traded companies.

The company has been earning profits continuously since 1971-72 and paying dividends

since 1976-77.

VISION:

A world-class engineering enterprise committed to enhancing stakeholder value.

MISSION:

To be an Indian multinational engineering enterprise providing total business

solutions through quality products, systems and services in the fields of energy, industry,

transportation, infrastructure and other potential areas.

BHEL manufactures over 180 products under 30 major product groups and caters

to core sectors of the Indian Economy viz., Power Generation & Transmission, Industry,

Transportation, Telecommunication, Renewable Energy, etc. The wide network of

BHEL's 14 manufacturing divisions, four Power Sector regional centers, over 100 project

sites, eight service centers and 18 regional offices, enables the Company to promptly

serve its customers and provide them with suitable products, systems and services --

efficiently and at competitive prices. The high level of quality & reliability of its products

is due to the emphasis on design, engineering and manufacturing to international

10

standards by acquiring and adapting some of the best technologies from leading

companies in the world, together with technologies developed in its own R&D centers.

SHAREHOLDING PATTERN AS ON 31-12-2009:

Category Voting (%)No. of Shares

held

Promoters holding

President of India (POI) 67.72 331510000

Nominees of POI 0 400

Total Promoter holding 67.72 331510400

Non-Promoters holding

Institutional Investors

Mutual Funds and UTI 5.14 25168090

Banks, FIs, and Insurance Companies 4.01 19619712

FIIs 17.03 83379194

Others

Directors & Relatives 0 400

Private Corporate Bodies 3.86 18875727

Indian Public 1.97 9604223

Foreign Nationals 0 1250

NRIs/OCBs 0.12 609975

Trust 0 13657

Shares in Transit (NSDL/CDSL) 0.15 737372

Total Non-Promoter holding 32.28 158009600

Grand Total 100 489520000

Table 2

11

2. BPCL

Burmah-Shell Refineries Limited (BSR) was incorporated on 3.11.1952 as a

Company under the Indian Companies Act, 1913, at Mumbai, with the authorized Capital

of Rs. 25 crore. A refinery was set up by this Company at Mahul, Mumbai. Secondly, the

Burmah-Shell Oil Storage & Distributing Company of India Ltd (BSM), a foreign

Company, established in England in 1928, was carrying on in India the business of

Distributing & Marketing petroleum products & for that purpose established places of

business at Mumbai & other places in India.

Pursuant to the agreement dated 23.12.1975 between the Government of India

(GOI), the Burmah-Shell Oil Storage and Distributing Company of India Ltd. (BSM) and

the Burmah Shell Refineries Ltd. (BSR), the GOI acquired 100 per cent equity share

holding (paid up value Rs. 1453.83 lakhs) of BSR on 24.01.1976, for a consideration of

Rs. 925 lakh. Simultaneously, through The Burmah Shell acquisition of Undertakings in

India Act, 1976, the GOI also acquired the right, title and interest and liabilities of BSM

in relation to its undertakings in India for a consideration of Rs. 2775 lakhs and by

notification dated 24.1.76, vested the same in BSR without any specific consideration

payable by BSR. The name of BSR was changed to Bharat Refineries Limited (BRL) and

subsequently to Bharat Petroleum Corporation Limited.

VISION:

Setting our sights on achieving excellence, we benchmark ourselves against the

highest global standards, forging ahead with enthusiasm and commitment.

MISSION:

Our focus on sustainable development remains unabated, with social

responsibility, healthy, safety, security and environmental care as our corporate goals.

12

We have redoubled our efforts to seek fresh avenues in our quest for renewable energies

creating a brighter future for generations to come.


Category Voting (%)

Government of India 54.93

LIC 10.9

BPCL Trust for Investment in shares 9.33

Banks/FIs/Mutual Funds 8.81

FIIs 8.39

Private Corporate Bodies 2.83

Government of Kerala 0.86

UTI 0.8

NRIs/Overseas Corporate Bodies 0.08

Others 3.07

Grand Total 100

Table 3

13

3. GAIL

GAIL (India) Ltd. (erstwhile Gas Authority of India Ltd), India's principal gas

transmission and marketing company, was set up by the Government of India in August

1984 to create gas sector infrastructure for sustained development of the natural gas

sector in the country. The 2800-km Hazira-Vijaipur-Jagdishpur (HVJ) pipeline became

operational in 1991. During 1991-93, three LPG plants were constructed and some

regional pipelines acquired, enabling GAIL to begin its regional gas distribution in

various parts of India. GAIL began its city gas distribution in Delhi in 1997 by setting up

nine CNG stations, catering to the city's vast public transport fleet. In 1999, GAIL set up

northern India's only petrochemical plant at Patan.

GAIL became the first Infrastructure Provider Category II Licensee and signed

the country's first Service Level Agreement for leasing bandwidth in the Delhi-Vijaipur

sector in 2001, through its telecom business GAILTEL. In 2001, GAIL commissioned

world's longest and India's first Cross Country LPG Transmission Pipeline from

Jamnagar to Loni.

GAIL today has reached new milestones with its strategic diversification into

Petrochemicals, Telecom and Liquid Hydrocarbons besides gas infrastructure. The

company has also extended its presence in Power, Liquefied Natural Gas re-gasification,

City Gas Distribution and Exploration & Production through equity and joint ventures

participations.Incorporating the new-found energy into its corporate identity, Gas

Authority of India was renamed GAIL (India) Limited on November 22, 2002

VISION:

Be the leading company in natural gas and beyond, with global focus, committed

to customer care, valuation creation for all stakeholders and environment responsibility.

MISSION:

To accelerate and optimize the effective and economic use of natural gas and its

fractions to the benefit of national economy.

14


Category Voting (%)

No. of Shares

held

Promoters holding

Government of India (GOI) 58.08 727405675

Total Promoter holding 58.08 727405675

Public holding


Mutual Funds and UTI 4.57 57227302

Banks and FI 0.91 11364641

State Government 7.34 91888984

Insurance companies 12.68 158787858

FIIs 13.57 169974003

Others

Corporate Bodies 0.59 7426419


NRIs/OCBs 0.08 942404


Grand Total 100 1268477400

Table 4

15

4. NTPC

India’s largest power company, NTPC was set up in 1975 to accelerate power

development in India. NTPC is emerging as a diversified power major with presence in

the entire value chain of the power generation business. Apart from power generation,

which is the mainstay of the company, NTPC has already ventured into consultancy,

power trading, ash utilization and coal mining. NTPC ranked 317 th in 2009 “Forbes

Global 2000”ranking of the World’s biggest companies.

The total installed capacity of the company is 31,134 MW (including JVs) with

15 coal based and 7 gas based stations, located across the country. In addition under JVs,

3 stations are coal based & another station uses naptha/LNG as fuel. By 2017, the power

generation portfolio is expected to have a diversified fuel mix with coal based capacity of

around 53000 MW, 10000 MW through gas, 9000 MW through Hydro generation, about

2000 MW from nuclear sources and around 1000 MW from Renewable Energy Sources

(RES). NTPC has adopted a multi-pronged growth strategy which includes capacity

addition through green field projects, expansion of existing stations, joint ventures,

subsidiaries and takeover of stations.

NTPC has been operating its plants at high efficiency levels. Although the

company has 18.79% of the total national capacity it contributes 28.60% of total power

generation due to its focus on high efficiency.

VISION:

A world-class integrated power major, powering India’s growth, with increasing

global presence.

16

MISSION:

Develop and provide reliable power, related products and services at competitive

prices, integrating multiple energy sources with innovative and eco-friendly technologies

and contribute to society.


Category Voting (%)

No. of Shares

held

Government of India 89.5 7379634400

FIIs 3.6 297078917


Banks & FIs 2.81 231213797

Private Corp. Bodies 1.21 99788139

Mutual Funds 0.61 50231251

NRI/OCBs 0.05 4536360

Others 0.04 3243075

Grand Total 100 8245464400

Table 5

17

5. ONGC

In 1955, Government of India decided to develop the oil and natural gas resources

in the various regions of the country as part of the Public Sector development. In April

1956, the Government of India adopted the Industrial Policy Resolution, which placed

mineral oil industry among the schedule 'A' industries, the future development of which

was to be the sole and exclusive responsibility of the state. Soon, after the formation of

the Oil and Natural Gas Directorate, it became apparent that it would not be possible for

the Directorate with its limited financial and administrative powers as subordinate office

of the Government, to function efficiently. So in August, 1956, the Directorate was raised

to the status of a commission with enhanced powers, although it continued to be under

the government. In October 1959, the Commission was converted into a statutory body

by an act of the Indian Parliament, which enhanced powers of the commission further.

The main functions of the Oil and Natural Gas Commission subject to the provisions of

the Act, were "to plan, promote, organize and implement programs for development of

Petroleum Resources and the production and sale of petroleum and petroleum products

produced by it, and to perform such other functions as the Central Government may,

from time to time, assign to it ". The act further outlined the activities and steps to be

taken by ONGC in fulfilling its mandate.

The liberalized economic policy, adopted by the Government of India in July

1991, sought to deregulate and de-license the core sectors (including petroleum sector)

with partial disinvestments of government equity in Public Sector Undertakings and other

measures. As a consequence thereof, ONGC was re-organized as a limited Company

under the Company's Act, 1956 in February 1994.

In the year 2002-03, after taking over MRPL from the A V Birla Group, ONGC

diversified into the downstream sector. ONGC will soon be entering into the retailing

18

business. ONGC has also entered the global field through its subsidiary, ONGC Videsh

Ltd. (OVL). ONGC has made major investments in Vietnam, Sakhalin and Sudan and

earned its first hydrocarbon revenue from its investment in Vietnam.

VISION:

To be world class Oil & Natural Gas Company integrated in energy business with

dominant Indian leadership and global presence.

MISSION:

Achieving excellence by leveraging competitive advantages in R&D and

technology with involved people. Imbibe high standards of business ethics and

organizational values. Strive for customer delight through quality products and services.

19


Category Voting (%)

No. of Shares

held

President of India (POI) 74.14 1,585,740,673

Banks, FIs, and Insurance Companies 4.91 105,054,973

FIIs 5.43 116,097,133

Mutual Funds & UTI 1.72 36,656,577

NRIs 0.04 816,829

Bodies Corporate

Government Companies 10.09 215,881,124

Others 1.9 40,590,974

Employees 0.1 22,43,606

Public 1.67 35,790,641

Grand Total 100 2,138,872,530

Table 6

20

6. SAIL

Steel Authority of India Limited (SAIL) is the leading steel-making company in

India. It is a fully integrated iron and steel maker, producing both basic and special steels

for domestic construction, engineering, power, railway, automotive and defense

industries and for sale in export markets.

Ranked amongst the top ten public sector companies in India in terms of turnover,

SAIL manufactures and sells a broad range of steel products, including hot and cold

rolled sheets and coils, galvanized sheets, electrical sheets, structural, railway products,

plates, bars and rods, stainless steel and other alloy steels. SAIL produces iron and steel

at five integrated plants and three special steel plants, located principally in the eastern

and central regions of India and situated close to domestic sources of raw materials,

including the Company's iron ore, limestone and dolomite mines. The company has the

distinction of being India’s second largest producer of iron ore and of having the

country’s second largest mines network. This gives SAIL a competitive edge in terms of

captive availability of iron ore, limestone, and dolomite which are inputs for steel

making.

SAIL's wide ranges of long and flat steel products are much in demand in the

domestic as well as the international market. This vital responsibility is carried out by

SAIL's own Central Marketing Organization (CMO) that transacts business through its

network of 37 Branch Sales Offices spread across the four regions, 25

Departmental Warehouses, 42 Consignment Agents and 27 Customer Contact Offices.

CMO’s domestic marketing effort is supplemented by its ever widening network of rural

dealers who meet the demands of the smallest customers in the remotest corners of the

country. With the total number of dealers over 2000, SAIL's wide marketing spread

ensures availability of quality steel in virtually all the districts of the country.

21

VISION:

To be a respected world-class corporation and the leader in Indian steel business

in quality, productivity, profitability, and customer satisfaction.

MISSION:

We create and nurture a culture that supports flexibility, learning and is proactive

to change. We value the opportunity and responsibility to make a meaningful difference

in people’s lives.

22


Category Voting (%)

No. of Shares

held

Promoters holding

Government of India (GOI) 85.82 3,544,690,285

Total Promoter holding 85.82 3,544,690,285

Non-Promoters holding


Mutual Funds and UTI 0.76 3,13,91,984

Banks and FI 0.39 1,62,26,276

Insurance Companies 6.45 26,63,41,385

FIIs 3.76 15,54,91,955

Others

Private Corporate Bodies 0.7 2,87,17,588

Indian Public 2.04 8,44,52,764

NRIs/OCBs 0.06 24,44,963

Other 0.02 6,43,345


Grand Total 100 4,130,400,545

Table 7

23

EQUITY VALUATION

24

“Every asset has a value; we just don’t know what it is,” states Professor

Damodaran. Thus valuation is the first step toward intelligent investing. Valuation of a

firm or an equity as a going concern is the basis for any investment exercise.

Knowing what an asset is worth and what determines that value is a pre-requisite

for intelligent decision making - in choosing investments for a portfolio, in deciding on

the appropriate price to pay or receive in a takeover and in making investment, financing

and dividend choices when running a business. Without original value, one is set floating

in a sea of random short-term price movements and gut feelings.

It is important for the Finance Manager in particular and other manager in general

to understand the process and method of valuing equity or a firm. The valuation of equity

is dependent on the basic financial concepts of Time Value of Money, Risk and Return

and Future Cash Flow.

VALUATION

The term “valuation” implies the task of estimating the worth/value of an asset, a

security or a business. The price an investor or a firm (buyer) is willing to pay to

purchase a specific asset/security would be related to this value.

EQUITY VALUATION

An equity valuation takes several financial indicators into account; these include

both tangible and intangible assets, and provide prospective investors, creditors or

shareholders with an accurate perspective of the true value of a company at any given

time.

Equity valuations are conducted to measure the value of a company given its

current assets and position in the market. These data points are valuable for shareholders

25

and prospective investors who want to find out if the company is performing well, and

what to expect with their stocks or investments in the near future.

Valuation methods based on the equity of a company typically include a thorough

analysis of cash accounts, as well as a forecast or projection of future dividends, future

earnings (revenue) and the distribution of dividends.

FEATURES OF EQUITY VALUATION

Following are the features of Equity Valuation;

Equity Valuation is a highly specialized process.

Like other assets in finance, the value of a stock is the Present Value of its Cash

Flow’s.

The total equity of a company is the sum of both tangible assets and intangible

qualities. Tangible assets include working capital, cash, and inventory and

shareholder equity. Intangible qualities, or intangible "assets," may include brand

potential, trademarks and stock valuations.

The valuation may also take the firm's enterprise value (EV) into account; this is

calculated by combining the net debt per share with the price per share.

Performance indicators include the price/earnings ratio, dividend yield, and the

Earnings Before Interest, Depreciation and Amortization (EBIDA).

Any company under consideration for sale needs proficient, objective valuation,

whether its stock is privately owned by one individual or publicly traded on one

or more of the major exchanges or in the over the counter market.

26

Stocks are typically valued as perpetual securities as corporations potentially have

an infinite life, and thus can pay dividends forever.

NEED OF EQUITY VALUATION

There are several reasons, for which we need Equity Valuation

Initial Public Offer

Merger and Demerger

Purchase/sale of equity stake by joint venture partners

Liquidation

Acquisition and takeover

Disinvestment, etc.

THE ROLE OF EQUITY VALUATION

Valuation is useful in a wide range of tasks. The role it plays, however, is

different in different arenas. The following section lays out the relevance of valuation in

portfolio management, in acquisition analysis and in corporate finance.

PORTFOLIO MANAGEMENT

The role that valuation plays in portfolio management is determined in large part

by the investment philosophy of the investor. Valuation plays a minimal role in portfolio

management for a passive investor, (Passive investors, feel that simply investing in a

market index fund may produce potentially higher long-term results.) whereas it plays a

larger role for an active investor. (Activist investors take positions in firms that have a

27

reputation for poor management and then use their equity holdings to push for change in

the way the company is run. Their focus is not so much on what the company is worth

today but what its value would be if it were managed well. )

Among security selectors, valuation plays a central role in portfolio management

for fundamental analysts, and a peripheral role for technical analysts.

VALUATION IN ACQUISITION ANALYSIS

Valuation should play a central part of acquisition analysis. The bidding firm or

individual has to decide on a fair value for the target firm before making a bid, and the

target firm has to determine a reasonable value for itself before deciding to accept or

reject the offer.

VALUATION IN CORPORATE FINANCE

There is a role for valuation at every stage of a firm’s life cycle. For small private

businesses thinking about expanding, valuation plays a key role when they approach

venture capital and private equity investors for more capital.

VALUATION FOR LEGAL AND TAX PURPOSES

Though it may seem, most valuations, especially of private companies, are done

for legal or tax reasons. A partnership has to be valued, whenever a new partner is taken

on or an old one retires, and businesses that are jointly owned have to be valued when the

owners decide to break up or businesses have to be valued for tax purposes when the

owner dies. While the principles of valuation may not be different when valuing a

business for legal proceedings, the objective often becomes providing a valuation that the

court will accept rather than the “right” valuation.

28

BENEFITS OF EQUITY VALUATION

A thorough analysis of tangible and intangible assets allows prospective

investors, shareholders and financial managers of a company to obtain critical

performance data about the company's business operations.

When an investor attempts to determine the worth of her shares based on the

fundamentals, it helps her make informed decisions about what stocks to buy or

sell.

Valuation compares the benefits of a future investment decision with its cost.

The equity valuation method takes several types of data into account, and can be

used as part of a prediction model to determine the economic future of the

company.

The valuation also provides some indication of the level of risk involved in

investing in the company.

The determination of right value of equity is essential to maintain a long term

success of investment.

29

EQUITY VALUATION VERSUS FIRM VALUATION

The value of the entire business, with both assets-in-place and growth assets; this

is often termed as enterprise valuation.

The second way is to just value the equity stake in the business, and this is called equity

valuation.

30

Therefore,

Equity Valuation, value just the equity stake in the business

Firm Valuation, value the entire firm, which includes, besides equity, the other

claimholders in the firm

EQUITY VALUATION MODELS

A good valuation model is simple and helps investors to make informed

decisions. Analysts use a wide range of models to value assets in practice, ranging from

the simple to the sophisticated. These models often make very different assumptions

about pricing, but they do share some common characteristics and can be classified in

broader terms. There are several advantages to such a classification -- it makes it easier to

understand where individual models fit into the big picture, why they provide different

results and when they have fundamental errors in logic.

31

Free Cash Flow to the Equity

Asset Based

Approach

Methods of comparable

(Ratio Based)

Present Value Method Discounted Cash Flow

1 Year Holding Period

Multi Year Holding

Period

Dividend Discount Model

Gordon Model

Multiple Growth Model

1. PRESENT VALUE METHOD :

The valuation model used to estimate the intrinsic value of a share is the present

value model. The intrinsic value of a share is the present value of all future amounts to be

received of the ownership of that share, computed at an appropriate discount rate. The

major receipts that come from the ownership of a share are the annual dividends and the

sale proceeds of the share at the end of holding period. These are to be discounted to find

their present value using a discount rate that is the rate of return required by the investor,

taking into consideration the risk involved and the investor’s other investment

opportunities.

32

Equity Valuation Models

EVA MVA

OtherApproaches

P/E Ratio PEG Ratio Relative P/E Ratio P/BV Ratio P/Sales ratio

The investment decision of the fundamental analyst to buy or sell a share is based

on the comparison between the intrinsic value of a share and its current market price. If

the market price is lower than the intrinsic value then such a share is bought and is

perceived to be under priced. If the market price is higher than the intrinsic value then

such a share would be considered as overpriced and is sold.

Following are two methods in Present Value Method,

A. ONE YEAR HOLDING PERIOD :

It is easy to start valuation with one year holding period assumption. Here an

investor intends to purchase a share now, hold it for one year and sell it off at the end of

one year. In this case the investor would be expected to receive an amount of dividend as

well as the selling price after one year.

B. MULTIPLE YEAR HOLDING PERIOD :

An investor may hold a share for a certain number of years and sell it off at the

end of his holding period. In this case he would receive annual dividends each year and

the sale price of the share at the end of the holding period.

DRAWBACK OF THE PRESENT VALUE METHOD :

Probably the biggest drawback in the previous two models was that we had to

predict a selling price.

The buyer of the stock, when we sell it, will presumably go through a similar

procedure to value the stock – in other words the buyer will be using future

dividends to value the stock.

The selling price of the stock should thus be the value of all future dividends.

33

Given investors can hold a common stock for over a year, it is useful to value a

stock over the investor’s expected holding period. In this case, the DDM model

can be used.

2. DIVIDEND DISCOUNT MODEL :

The simplest model for valuing equity is the dividend discount model. The only

cash flow we receive from a firm when we buy publicly traded stock is the dividend and

appreciation of its value. The appreciation of the value is nothing but the expected price

of the stock. But the expected price is itself determined by the future dividends. Hence

the value of a stock is the present value of expected dividends on it.

The General Model,

The rationale for the model lies in the present value rule - the value of any asset is

the present value of expected future cash flows discounted at a rate appropriate to the

riskiness of the cash flows.

There are two basic inputs to the model - expected dividends and the rate of

return. To obtain the expected dividends, we make assumptions about expected future

growth rates in earnings and payout ratios .To know more about DDM model first we

have to understand growth periods i.e. High growth period, transition period and stable

growth period.

34

∞

Value per share of stock = ∑ DPS t=1

(1+ k)

A. GORDON MODEL :

Gordon Model also known as Constant Growth Model. The Gordon growth

model can be used to value a firm that is in 'steady state' with dividends growing at a rate

that can be sustained forever. The Gordon growth model is best suited for firms growing

at a rate comparable to or lower than the nominal growth in the economy and which have

well established dividend payout policies that they intend to continue into the future. The

dividend payout of the firm has to be consistent with the assumption of stability, since

stable firms generally pay substantial dividends.

According to the model, the value of the stock is given by,

Where,

35

Value of the Stock = DPS (1+g) r-g

DPS = Expected Dividends Per Share during next period

r = Required rate of return for equity investors

g = Growth rate in dividends forever

DRAWBACK OF THE GORDON METHOD :

The use of this model is restricted to firms that are growing at a stable rate. The

assumption that the growth rate in dividends has to be constant over time is a

difficult assumption to meet, especially given the volatility of earnings.

Assumed growth rate may be incorrect.

The growth rate is equal to the required rate of return, then the value of the stock

approaches infinity. If the growth rate is higher then the required rate of return,

then the value of the stock becomes negative. A firm cannot grow in the long-

term at a rate in the economy.

The false assumption is that investors will hold shares for infinite period of time.

B. MULTIPLE GROWTH MODEL :

The constant growth assumption may not be realistic in many situations. The

growth in dividends may be at varying rates. A typical situation for many companies may

be that a period of extraordinary growth (either good or bad) will prevail for a certain

number of years after which growth will change to a level at which it is expected to

continue indefinitely. This situation can be represented by a Multiple Growth Model also

known as - two stage growth model.

In this model the future time period is viewed as divisible into two different

growth segments the initial extraordinary growth period and the subsequent constant

growth period. During the initial period growth rates will be variable from year to year

while during the subsequent years the growth rate will remain constant from year to year.

36

The model can be adapted to value companies that are expected to post low or

even negative growth rates for a few years and then revert back to stable growth.

According to the model, the value of the stock is given by,

DRAWBACK OF THE MULTIPLE GROWTH MODEL :

There are three problems with the two-stage dividend discount model – the first

two would apply to any two-stage model and the third is specific to the dividend discount

model.

The practical problem is in defining the length of the extraordinary growth period.

Since the growth rate is expected to decline to a stable level after this period, the

value of an investment will increase as this period is made longer. It is difficult in

practice to convert these qualitative considerations into a specific time period.

The second problem with this model lies in the assumption that the growth rate is

high during the initial period and is transformed overnight to a lower stable rate at

the end of the period. While these sudden transformations in growth can happen,

it is much more realistic to assume that the shift from high growth to stable

growth happens gradually over time.

The focus on dividends in this model can lead to skewed estimates of value for

firms that are not paying out what they can afford in dividends. In particular, we

will under estimate the value of firms that accumulate cash and pay out too little

in dividends.

37

Value of the stock = PV of dividends during supernormal growth + PV of terminal price

3. DISCOUNTED CASH FLOW :

The discounted cash flow (or DCF) approach describes a method of valuing a

project, company, or asset using the concepts of the time value of money. A

valuation method used to estimate the attractiveness of an investment opportunity.

All future cash flows are estimated and discounted to give them a present value.

There are different types of DCF model i.e. Cash flow to equity model, Cash flow to firm

model, adjusted present value model.

FREE CASH FLOW TO EQUITY (FCFE) :

The free cash flow model estimates the value of equity as the present value of the

expected free cash flow to equity over time. This is a measure of how much cash can be

paid to the equity shareholders of the company after all expenses, reinvestment and debt

repayment. The free cash flow to equity is defined as the residual cash flow left over after

meeting interest and principal payment and providing for capital expenditure to maintain

existing assets and create new assets for future growth.

38

FCFE VALUATION WORKS BEST :

This approach is easiest to use for assets (firms) whose

• Cash flows are currently positive and

• Can be estimated with some reliability for future periods, and

• Where a proxy for risk that can be used to obtain discount rates is

available.

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

39

• 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

DRAWBACKS OF FCFE MODEL :

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.

FCFE VALUATION MODELS :

A. THE CONSTANT GROWTH FCFE MODEL :

The constant growth FCFE model is designed to value firms that are growing at a

stable rate and are, hence, in steady state. The value of equity, under the constant growth

model, is a function of the expected FCFE in the next period, the stable growth rate and

the required rate of return. From this model value will be calculated as follows,

B. THE TWO-STAGE FCFE MODEL :

The two stage FCFE model is designed to value a firm which is expected to grow

much faster than a stable firm in the initial period and at a stable rate after that. The two

stage FCFE model is designed to value a firm which is expected to grow much faster

than a stable firm in the initial period and at a stable rate after that. From this model value

will be calculated as follows,

40

Value of Equity = FCFE r-g

i.e.

The terminal price is generally calculated using the infinite growth rate model.

This model makes the same assumptions about growth as the two-stage dividend

discount model, i.e., that growth will be high and constant in the initial period and drop

abruptly to stable growth after that. It is different because of its emphasis on FCFE rather

than dividends. Consequently, it provides much better results than the dividend discount

model when valuing firms which either have dividends which are unsustainable (because

they are higher than FCFE) or which pay less in dividends than they can afford to (i.e.,

dividends are less than FCFE).

C. THE THREE STAGE FCFE MODEL :

The Three Stage FCFE Model also known as E model which is designed to value

firms that are expected to go through three stages of growth - an initial phase of high

growth rates, a transitional period where the growth rate declines and a steady state

period where growth is stable. The E model calculates the present value of expected free

cash flow to equity over all three stages of growth.

From this model value will be calculated as follows,

41

Value of Equity = FCFEt + Pn (1+ r )t (1 + r)n

Pn = FCFEn+1 r – gn

Value of Equity = PV of FCFE + PV of terminal price

Where,

P0 = Value of the stock today

FCFEt = FCFE in year t

ke = Cost of equity

Pn2 = Terminal price at the end of transitional period = FCFEn2+1

r-gn

n1 = End of initial high growth period

n2 = End of transition period

Since the model allows for three stages of growth and for a gradual decline from

high to stable growth, it is the appropriate model to use to value firms with very high

growth rates currently. The assumptions about growth are similar to the ones made by the

three-stage dividend discount model, but the focus is on FCFE instead of dividends,

making it more suited to value firms whose dividends are significantly higher or lower

than the FCFE.

If firm is

Large and growing at a rate close to or less than growth rate of the economy or

Constrained by regulation from growing at rate faster than the economy

Has the characteristic of a stable firm (average risk & reinvestment rates)

Then use a stable growth model.

42

If firm is

Is large & growing at a moderate rate (Overall growth rate + 10%) or

Has a single product & barriers to entry with a finite life (e.g. Patents)

Then use a 2-stage growth model.

If firm is

Is small and growing at a very high rate (> Overall growth rate + 10%) or

Has significant barriers to entry into the business

Has firm characteristics that are very different from the norm

Then use a 3-stage or n-stage model.

4. ASSET BASED APPROACH :

Asset Based Approach focuses on determining the value of net assets from the

perspective of equity share valuation. It should determine whether the assets should be

valued at book, market, and replacement or liquidation value. More often than not, they

are (and should be) valued at book value, that is, original acquisition cost minus

accumulated depreciation, as assets are normally acquired with the intent to be used in

business and not for resale. Thus valuation of assets is based on the going concern

concept.

Apart from tangible assets, intangible assets, such as goodwill, patents,

trademark, brands, know-how, and so on, also need to be valued satisfactorily. It may be

useful to adopt the super profit method to value some of these assets.

To arrive at the net assets value, total external liabilities (including preference

share capital) payable are deducted from total assets (excluding fictitious assets). The

company’s net assets are computed as per equation,

43

Net Assets = Total Assets – Total External liabilities

The value of net assets is also known as net worth or equity/ordinary

shareholders’ funds. Assuming the figure of net assets to be positive, it implies the value

available to equity shareholders after the payment of all external liabilities. Net assets per

share can be obtained by, dividing net assets by the number of equity shares issued and

outstanding. Thus,

The value of net assets is contingent upon the measure of value adopted for the

purpose of valuation of assets and liabilities. In the case of book value, assets and

liabilities are taken at their balance sheet values. In the market value measure, assets

shown in the balance sheet are revalued at the current market prices.

The net assets valuation based on book value is in tune with the going concern

principle of accounting. In contrast, liquidation value measure is guided by the realizable

value available on the winding up/ liquidation of a corporate firm.

Liquidation value is the final net asset value (if any) per share available to the

equity shareholder. The value is given as per equation,

44

Net Asset = (Liquidation Value of assets – Liquidation Expenses – Total External Liabilities) Per Share Number of Equity Share Issued and Outstanding

Net Assets per Share = Net Assets

Number of Equity Shares issued and outstanding

DRAWBACK OF THE ASSET BASED APPROACH :

The Asset Based Approach is naturally appealing in that it indicates the net assets

backing per Equity Shares. However the approach ignores the future earnings/ cash flow

generating ability of the company’s assets.

5. COMPARABLE COMPANY APPROACH (RATIO BASED) :

This method is based on the principal of substitution which states that “one will

pay no more for an item than the cost of acquiring an equally desirable substitute”.

The objective of comparable company approach is to value the assets based on

how similar assets are priced in the market place. It is also termed as relative valuation.

In relative valuation, the value of an asset is derived from the pricing of 'comparable'

assets, standardized using a common variable such as earnings, cash flows, book value or

revenues. Widely used multiples are price-earnings ratio, price to book value ratio, price

to sales ratio etc.

APPLICATION OF COMPARABLE COMPANY APPROACH :

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

• There exists some common variable that can be used to standardize the

price

This approach tends to work best for investors

• Those who have relatively short time horizons

• Are judged based upon a relative benchmark (the market, other portfolio

managers following the same investment style etc.)

45

• Can take actions that can take advantage of the relative mispricing; for

instance, a hedge fund can buy the undervalued and sell the overvalued

assets.

ADVANTAGES OF COMPARABLE COMPANY APPROACH :

Easy to understand and apply; uses easily available current market data

eliminating the need for projecting cash flows. Valuation based on multiples and

comparable firm can be done with fewer assumptions and at a faster rate than the

discounted cash flow valuation.

The relative valuation is simple and easy to understand and present to clients than

DCF method.

The relative valuation measures the relative value of assets rather than intrinsic

value and hence it reflects current atmosphere of the market.

DISADVANTAGES OF COMPARABLE COMPANY APPROACH :

Difficult to find companies that are truly comparable - listed companies are

typically larger and less risky.

Because we don’t make assumptions, we may ignore the role of key fundamentals

such as growth, ROC, and cash flows.

Relative valuation captures current market sentiment, so it may also incorporate

market misevaluations. Each step in valuing using multiples analysis is subjective

46

and provides an opening for manipulation of results. The multiples approach can

justify a wide range of values for businesses.

The lack of explicit assumptions makes a relative valuation easy to manipulate

A. P/E RATIO :

When it comes to valuing stocks, the price/earnings ratio is one of the oldest and

most frequently used metrics. It is also known as "price multiple" or "earnings

multiple". A valuation ratio of a company's current share price compared to its per-share

earnings.

A high P/E suggests that investors are expecting higher earnings growth in the

future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us

the whole story by itself. It's usually more useful to compare the P/E ratios of

one company to other companies in the same industry, to the market in general or against

the company's own historical P/E. It would not be useful for investors using the P/E ratio

as a basis for their investment to compare the P/E of a technology company (high P/E) to

a utility company (low P/E) as each industry has much different growth prospects.

DRAWBACK OF P/E RATIO :

Using the Price to earnings (P/E) ratio ignores the cost of capital, time value of

money and is sensitive to the accounting policies adopted.

Because the P/E ratio does not reflect future earnings growth, we use the PEG

ratio to determine whether the market valuation is supported by the predicted future

earnings growth rates.

47

P/E Ratio = Market price per share (MPS) Earning per share (EPS)

B. PEG RATIO :

The PEG ratio was developed to address shortcomings in the use of the P/E ratio.

Specifically, it was created to adjust the P/E ratio for relative projected future earnings

growth rates of different firms. A ratio used to determine a stock's value while taking into

account earnings growth.

APPLICATIONS OF THE PEG RATIO :

Since the market tends to price equities relative to their sector, a meaningful

comparison of PEG ratios (and P/E ratios) demands viewing them against the

sector or industry average.

To identify undervalued and overvalued equities.

A common application is applied to emerging market equities (where earnings

growth rates are high and uncertain). As a general rule of thumb, when the PEG

ratio is approaching a value of 1.0, the firm's equity is considered "fairly" valued.

If the PEG ratio is less than 1.0, the equities are considered "undervalued". If the

PEG ratio is greater than 1.0, the equities are considered "overvalued".

48

PEG Ratio = P/E Ratio Annual EPS Growth

c. RELATIVE P/E RATIO :

Relative P/E compares the current absolute P/E to a benchmark or a range of past

P/Es over a relevant time period, such as the last 10 years. Relative P/E shows

what portion or percentage of the past P/Es the current P/E has reached. Relative P/E

usually compares the current P/E value to the highest value of the range, but investors

might also compare the current P/E to the bottom side of the range, measuring how close

the current P/E is to the historic low. The relative P/E will have a value below 100% if

the current P/E is lower than the past value (whether the past high or low). If the relative

P/E measure is 100% or more, this tells investors that the current P/E has reached or

surpassed the past value.

Suppose a company's P/Es over the last 10 years have ranged between 15 and

40. If the current P/E ratio is 25, the relative P/E comparing the current P/E to the highest

value of this past range is 0.625 (25/40), and the current P/E relative to the low end of the

range is 1.67 (25/15). These values tell investors that the company's P/E is currently

62.5% of the 10-year high and 67% higher than the 10-year low.

d. P/BV RATIO :

It reflects the market’s expectation. Book value of an asset reflects its original

cost. It might deviate significantly from market value if the earning power of the asset

has increased or declined significantly since its acquisition.

The Price/ Book value ratio is the ratio of market value of equity to book value of

equity, i.e. the measure of stakeholders’ equity in the balance sheet. It is calculated as

follows,

49

Price/ Book value ratio = Market Value of Equity Book Value of Equity

ADVANTAGES :

For investors who instinctively mistrust discounted cash flow estimates of value,

the book value is a much simpler benchmark for comparison.

Price-book value ratios can be compared across similar firms for signs of under or

over valuation.

Even firms with negative earnings.

DISADVANTAGES :

Affected by accounting decisions on depreciation and other variables

Completely ignores intangible assets.

e. P/SALES RATIO :

A ratio for valuing a stock relative to its own past performance, other companies

or the market itself. Price to sales is calculated by dividing a stock's current price by its

revenue per share for the trailing 12 months:

The price-to-sales ratio can vary substantially across industries;

therefore, it's useful mainly when comparing similar companies. Because it doesn't take

any expenses or debt into account, the ratio is somewhat limited in the story it tells.

50

Price to Sales Ratio = Share Price Revenue Per Share

6. OTHER APPROACHES :

In recent years a number of new approaches to measure value has been developed

and practiced. The two major approaches are,

A. ECONOMIC VALUE ADDED :

Economic Value Added is a financial performance method to calculate the true

economic profit of a corporation. EVA method is based on the past performance of the

enterprise. The underlying economic principle in this method is to determine whether the

firm is earning higher rate of return on the entire invested funds then the cost of such

funds. If the answer is positive, the firm’s management is adding to the shareholders

value by earning extra return for them.

It is a single, value-based measure that was intended to evaluate business

strategies, capital projects and to maximize long-term shareholders wealth. Value of

Shareholder is very important and therefore EVA is Value-Based Metrics seen as good

measures of a company’s performance. EVA can be used for the setting of the goals,

capital budgeting, corporation value etc. Value of the stock with the help of EVA can be

calculated as follows,

Where,

NOPAT= Net operating profit after tax

TCE = Total capital employed

WACC = weighted average cost of capital

51

EVA = NOPAT – (WACC * TCE)

ADVANTAGES OF EVA :

It is directly linked to creation of shareholders wealth over time

The mechanism of EVA forces management to recognize the cost of equity in all

its decision from board room to the shop floor

It is used to assess the likely impact of competing strategies on shareholders

wealth and thus help management to select that one that will best serve the

shareholders.

Improves the overall capital efficiency.

EVA implementation will result in a better business performance due to better

understanding of objectives.

Allows managers to make better decisions.

DISADVANTAGE OF EVA :

EVA provides information that is obvious but offers no solutions in much the

same way as historical financial statement.

EVA is based on financial accounting methods that can be manipulated by

managers

Shareholder-centric

The emphasis of EVA on improving business-unit performance, it does not

encourage collaborative relationship between business unit managers.

B. MARKET VALUE ADDED :

MVA measures the change in the market value of the firm’s equity vis-à-vis

equity investment. Market Value Added (MVA) is the difference between the current

market value of a firm and the capital contributed by investors. If MVA is positive, the

52

firm has added value. If it is negative, the firm has destroyed value. The amount of value

added needs to be greater than the firm's investors could have achieved investing in the

market portfolio.

Though the concept of MVA is normally used in the context of equity investment

therefore it has greater relevance for equity shareholder. Value of the stock with the help

of MVA can be calculated as follows,

DRAWBACKS OF MVA :

The market value added Approach is very much dependent on the market price of

the target company. As the share price is dependent on various factors, viz., market

conditions, its own performance, some natural calamity, investor’s sentiments or

perceptions about the market. Because of all this factors the share price of the company

may fluctuate, so it becomes difficult to get the best price. Other drawbacks are,

Only on listed shares

Depends on capital market

53

MVA = Market value of firm’s equity – Equity capital

investment/funds

DCF FRAMEWORK

54

The following section will present the theoretical recommendations on each

aspect that was included in the empirical study.

ANALYSIS OF HISTORICAL PERFORMANCE:

A crucial step in the DCF model is to collect and analyze relevant historical

information in order to evaluate the historical performance. A solid understanding of the

past performance will enable reasonable forecasts of future performance.

The historical information should at a minimum include income statements

and balance sheets. Additional information such as cash flow statements and

relevant notes may also add value. The number of years of historical data included

should be sufficient to determine historical performance and business trends.

In order for the historical information to provide an understanding of

historical performance it needs to be analyzed. The analysis is performed through

calculating historical financial ratios such as sales growth, profit margins, capital

expenditure etc. Through analyzing these ratios over a number of years the historical

performance will become evident and reasonable assumptions regarding future

performance can be made (Jennergren 2007).

FORECASTING FUTURE PERFORMANCE:

The analysis of the historical performance should provide a clarifying

connection to the assumptions that are made regarding future performance. These

assumptions should be able to generate future expected income statements and

balance sheets from which the free cash flow can be derived. Furthermore, the

assumptions should be clearly stated in a separate section.

The forecasting of a firm’s financial performance is divided into two

periods: the explicit forecast period and the post-horizon period. For each given year

55

in the explicit forecast period the corresponding income statement and the balance

sheet is used to derive the expected annual free cash flow.

In some implementations of the DCF model it is a requirement that the explicit

forecast period is not shorter than the economic life of the firm’s property, plant and

equipment, (Jennergren 2007 and Jennergren 2008).

According to Jennergren (2007a) and Koller et al (2005) the explicit forecast

period should consist of at least 10-15 years. Earlier studies have however

concluded that practitioners often use a shorter forecasting period, often no longer

than five years (Levin and Olsson 1995 and Barker 1999).

Through forecasting entire income statements and balance sheets an analysis

using financial ratios is possible. This analysis can be used to determine the fairness

of the assumptions regarding the future (Levin 1998).

ESTIMATING THE COST OF CAPITAL:

The discount factor for the free cash flows must represent the risk faced

by all investors. The weighted average cost of capital (WACC) combine the required

rates of return for net debt (rnd) and equity (re) based on their market values. The tax

effect on cost of net debt is accounted for in the WACC. Through using a constant

WACC it is implicitly assumed that the capital structure will remain unchanged. The

WACC is defined as follows:

WACC = (Proportion of Equity * Cost of Equity) +

(Proportion of Debt * Cost of Debt)

The components of the WACC should be calculated accordingly:

56

The cost of net debt should be calculated using the company’s yield to

maturity on its long-term debt.

The marginal tax rate should be used as the tax rate in the WACC formula,

which is the tax that the firm would pay if the financing or non

operating items were eliminated.

For mature companies, the target capital structure is often

approximated by the company’s current debt-to-value ratio, using market

values of debt and equity.

The Capital Asset Pricing Model (CAPM) is used to determine the required

rate of return on equity.

CAPM should be calculated accordingly:

Local government default-free bonds should be used to estimate the risk-free rate.

Ideally, each cash flow should be discounted using a government bond with a

similar maturity.

To estimate the beta, first measure a raw beta using regression which should at

least contain five years of monthly returns and then improve the estimate

by using industry comparables.

No single model for estimating the market risk premium has gained

universal acceptance. Based on evidence from the different used models

suggests a market risk premium around 5 percent (Koller et al 2005).

One should note that, given the WACC formula, it is possible to use the required

return on equity as the discount factor if it is assumed that the future target

capital structure will be 100 percent equity and 0 percent net debt. A net debt

of zero requires that the model assumes that no interest bearing liabilities or

financial assets will exist in the target in the future, in this case the tax rate

become irrelevant in the WACC.

57

ESTIMATING THE CONTINUING VALUE:

As already mentioned the forecasting of a firm’s financial performance is

divided into two periods: the explicit forecast period and the post-horizon period.

During the explicit forecast period the firm is expected to transform into a steady state.

When the firm has reached the steady state the terminal value is calculated by a

continuing value formula.

The continuing value formula is applied to the first year in the post-horizon

period which therefore becomes representative for all subsequent years in the steady

state. The explicit forecast period must be long enough for the company to reach a steady

state. According to Koller et al (2005) the following characteristics must be fulfilled in

order for a company to truly be in steady state

The company should grow at a constant rate and reinvests a constant

proportion of its operating profits into the business each year.

The company earns a constant rate of return on new invested capital.

The company earns a constant return on its base level of invested capital.

If these conditions are fulfilled in steady state the free cash flow will grow at a

constant rate consistent with the assumed terminal growth rate and thereby a continuing

value formula can be applied. The DCF model should be constructed in such a way that

an extra year in steady state could be added, this enables to verify if the company truly is

in steady state, since the free cash flow during the extra year is supposed to grow

with the terminal growth rate (Jennergren 2007).

The continuing value formula that is commonly recommended is the

Gordon growth model. It should be noted that even though the terminal value is

calculated by a simple Gordon growth model it does not imply that it is unimportant

and irrelevant for the value of the firm (Levin and Olsson 2000). Earlier studies have

shown that a significant part of the total firm value is in the terminal value (Levin and

58

Olsson 1995). In addition, recent empirical studies have indicated that the terminal

value calculations are crucial for the overall accuracy of a valuation model.

The terminal growth rate in steady state must be less than or equal to that of the

economy (the GDP growth). A higher growth rate would eventually make the company

unrealistically large compared to the aggregated economy.21 The growth rate is often

assumed to equal the rate of inflation (Francis et al 1997).

FINANCIAL CASH FLOW:

The financial cash flow consists of transactions to or from all investors in

the firm. Hence, the financial cash flows consist of all transactions with those providing

capital to the firm. Financial cash flows should be identical to the free cash flows. Thus,

through including the financial cash flows it is possible to check that the free cash

flow calculations are correct. As a result it is possible to identify potential

mistakes concerning the free cash flow calculations (Koller et al 2005 and

Jennergren 2007).

FORECASTING PROCEDURE:

Regarding the forecasting procedure, the following theoretical conditions are used

to determine its quality

The number of years in the explicit forecast period should be at least 10-

15 years.

The forecasting should include entire income statements and balance

sheets.

The assumptions on future expected performance should be clearly linked

from an analysis of historical financial ratios.

The assumptions should be clearly stated in a separate section.

59

DISCUSSION ON

EMPIRICAL RESULTS

60

The ultimate aim of any report is to analyze the topic on certain target population

and likewise we have to analyze six companies’ intrinsic share price based on past

performance, current scenarios and statistics of RBI.

The basis of DCF model is to collect and analyze relevant historical accounting

information in order to evaluate historical performance. A solid understating of the past

performance as well as the current market scenario enables reasonable forecasts of future

performance and that’s why these variables played an important role in our analysis.

Before starting with our analysis we have considered financial year 2008-09 as an

abnormal year because of global recession and our conclusions as well as

recommendations are done when economy gets stabilize. So comparison of the intrinsic

share price with current market price is done on the closing price of the companies’ share

on 1st February, 2010 in NSE.

According to Jennergren (2007), a DCF model must at a minimum include entire

historical income statements and balance sheets. However, additional information in

the notes of the financial statements may provide supplementary information

regarding past performance that might improve the accuracy of predicted future

performance. Therefore the empirical findings of the quantity and quality of historical

information were unexpected and this is the main reason for our various assumptions.

We have considered risk-free rate of 8.01325% which was published on RBI

website. Apart from this risk-premium is estimated at 7.00% for PSEs. The corporate tax

rate is considered to be 33.99% for all estimated periods. We have calculated cost of

equity based on Capital Asset Pricing Model (CAPM) and then we come up Weighted

Average Cost of Capital (WACC). The Discounted Cash Flow model we have used is

based on the revenue generation and what percentage of revenue other component is i.e.

what percentage of revenue Free Cash Flow (FCF) is and likewise. We have considered

61

estimation of 10 years and from 11th year onwards everything will remain stable and the

year 2019-2020 is considered to be the horizon year.

Our analyses are as follows:

1. BHEL :

Based on the past performance and current trends in energy sector we have

assumed the growth rate of revenue at 20.00% and NOI growth rate of 15.00% of

revenue annually. The depreciation is stable at 4.00% every year while working capital

is reduced to 3.00% and capital expenditure increases at 4.50%. WACC is 15.00%. In

the year 2019-20 the revenue growth stabilize at 10.00%.

Table 8 shows the calculation of the company by DCF model. Based on this

calculation the present value of terminal value comes at Rs. 380172.93 cr. and present

value of cash flow comes at Rs. 39465.25 cr. which gives total value of the firm of Rs.

121180.85 cr. and after deducting the value of debt and dividing the figure with total

outstanding share the intrinsic share price of the company comes to Rs. 2472.45 while

the closing price on 1st February, 2010 on NSE was Rs. 2405.50. So there is a deviation

of Rs. 66.95.

62

63

2. BPCL :

The past performance shows that the revenue is growing at 16.00% annually but

on the other side the expenditure is also growing nearly at same percentage and that’s

why the NOI is assumed at just 0.75% of revenue. The depreciation is also assumed at

0.75% every year while working capital is reduced at 2.00% and capital expenditure

increases at 2.06%. WACC is 10.00%. In the year 2019-20 the revenue growth stabilize

at 10.00%.



value of cash flow comes at Rs. 19194.04 cr. which arrives total value of the firm at Rs.


outstanding share the intrinsic share price of the company comes to Rs. 560.23 while the

closing price on 1st February, 2010 on NSE was Rs. 584.05. So there is a difference of

Rs. 23.82.

64

65

3. GAIL :

The historical financial results of GAIL and current situation in gas sector, its

revenue is growing at 12.00% annually while NOI is also growing at the same rate of

revenue. The depreciation is assumed to be 3.50% every year while working capital is

increasing at 2.25% and capital expenditure at 7.00%. WACC is 13.00%. In the year

2019-20 the revenue growth stabilize at 10.00%.





outstanding share the intrinsic share price of the company comes at Rs. 412.19 while the

closing price on 1st February, 2010 on NSE was Rs. 412.60. So there is no much

difference and the share looks at its actual value.

66

67

4. NTPC :

Based past performance and current trends in the power sector we have assumed

the revenue growth of the company at 15.00% annually but the profit margin looks good

in this company and average NOI comes at 17.00% of revenue. The depreciation is

assumed at 5.50% every year while working capital is increased at 2.25% and capital

expenditure at just 2.00%. WACC is 12.00%. In the year 2019-20 the revenue growth

stabilize at 10.00%.



value of cash flow comes at Rs. 3348.26 cr. which gives the total value of the firm of Rs.

195477.10 cr. and after deducting the value of debt of 34567.80 and dividing the figure

with total outstanding share the intrinsic share price of the company comes at Rs. 195.13

while the closing price on 1st February, 2010 on NSE was Rs. 211.30. So there is a

difference of Rs. 16.17.

68

69

5. ONGC :

Based on the past performance and current scenario in oil & gas sector the

company’s revenue growth rate is assumed at 6.00% and NOI growth rate is 20.00% of

revenue. The depreciation is assumes at 15.00% every year while working capital

increases at 1.00% and capital expenditure at 16.00%. WACC is 14.00%. In the year

2019-20 the revenue growth stabilize at just 4.00%.




220827.50 cr. and after deducting the value of debt of just Rs. 26.74 cr. and dividing the

figure with total outstanding share the intrinsic share price of the company comes to Rs.

1032.31 while the closing price on 1st February, 2010 on NSE was Rs. 1101.55. So there

is a deviation of Rs. 69.24.

70

71

6. SAIL :

The performance of the company in past and the recent industry trend in steel

sector gives us an assumption of various growth rates. The revenue growth rate is

assumed at 8.00% while the NOI as a percentage of revenue is 19.00%. The depreciation

is also assumed at 2.75% every year while working capital increases at 2.00% and capital

expenditure at 5.00%. WACC is 16.00%. In the year 2019-20 the revenue growth

stabilize at 5.00%.



value of cash flow comes at Rs. 49676.36 cr. which arrives total value of the firm at Rs.


outstanding share the intrinsic share price of the company comes to Rs. 243.36 while the

closing price on 1st February, 2010 on NSE was Rs. 213.50. So there is a difference of

Rs. 29.86.

72

73

Thus after each such a deep empirical research our findings comes as follows:

INTRINSIC VALUE AND CURRENT MARKET PRICE

Company Intrinsic value Market price on 1st

February, 2010Difference

BHEL 2472.45 2405.50 66.95 (U)

BPCL 560.23 584.05. 23.82 (O)

GAIL 412.19 412.60 0.41 (O)

NTPC 195.13 211.30 16.17 (O)

ONGC 1032.31 1101.55 69.24 (O)

SAIL 243.36 213.50 29.86 (U)

*U=Undervalued

*O=Overvalued Table 14

74

CONCLUSION

75

The objective behind this project was to compare the intrinsic value of the equity

with the ongoing market price. The intrinsic value and ongoing market price are more or

less similar. Market price is the investors’ understanding regarding the value of the

equity.

This conclusion is on the basis of our DCF model analysis of the company’s

equity. However this conclusion is not exactly match with the market price, because the

market value of the stock is a function of supply and demand in the market and not a

theoretical correct value. Market price is also affected by its own performance, market

condition, investors’ sentiments and investors’ perceptions about the market.

Here the analysis is done with use the of historical data and the estimation are

made for the long period of 10 years, which shows the equity value are calculated are

long-term value and in the long period market price will reach to intrinsic value.

From the Table 14 given in previous page we can say that BHEL is traded at

Rs.2405.05 which is Rs.66.95 lower than its intrinsic value and SAIL are traded at

Rs.213.50 which is also Rs.29.86 lower price than its intrinsic value.

BPCL is traded at Rs.584.05 which is Rs. 23.82 higher than its intrinsic value,

NTPC is traded at Rs.211.30 which is Rs.16.17 higher than it intrinsic value. The ONGC

is also priced Rs. 69.24 higher than its intrinsic value.

There seems to be no difference in GAIL’s intrinsic price and current market

price.

76

Documents

Fundamental analysis of stock mini project