UNIT-II

CORPORATE VALUATION
Contents
Concept of Value; Value Creation through Required Rate
of Return-NPV and IRR Approach;
Book Value of the Corporate Entity
-Intrinsic Value; Adjusted Book Value of the Corporate
Unit;
Current Market Valuation Model; Cost Theory of
Valuation; Earnings Theory of Valuation; The Gordon
Model of Valuation; Discounted Cash Flow Model.
 Concept of value
• Value is a term signifying the material or monetary worth of a thing.,
which can be estimated in terms of medium of exchange. In other
words, it is an assessment resulting in an expression of opinion rather
than an arithmatical exactness.
• Value can have different meaning at different times, to different people
and under different circumstances.
• E,g Many owners and managers often ask,
• How much is our business worth? And how much is theirs?
• What is the right price of that company?
• What is the right price of our company?
Definition of value
Every one has an opinion of value about a business, a tangible asset. Or
intangible asset but actually the term ‘value” means different things to
different people.
The Webster’s dictionary puts value as:
“A fair return or equivalent in goods, services, or money for something
exchanged , the monetary worth of something, marketable price, relative
worth, utility or importance, something intrinsically valuable or
desirable”.
In business valuation, the value of an interest in a business is considered
to be equal to the future benefits that are to be received from the
business, discounted to the present value, at an appropriate discount
rate.
 Various Expression of value
1. Fair market value: Fair market value is a term with several
meanings in the financial world. In investing, it refers to an asset's
sale price agreed upon by a willing buyer and seller, assuming both
parties are knowledgeable and enter the transaction freely.
It is the price at which the property would charge hands between a
willing buyer and a willing seller, where both are not any
compulsion to buy and sell and they have reasonable knowledge of
relevant facts and information.Fair value sometimes as fair market
value without discounts. In the event of corporate mergers, sell-offs
ie. Sale of share, debenture etc. fair value can be said to be the
amount will compensate an owner.
If we are examining a firm whose stock or debt is traded in a
securities market. This is the value of the debt or equity securities as
reflected in the bond or stock markets's perception of the firm
***
2. Book value: Book value is the historical value to the shareholders’
equity, net worth, and net book value. It is the difference between total
assets and total liabilities appearing in the balance sheet of a company
on a particular date. Book value refers to the total amount a company
would be worth if it liquidated its assets and paid back all its liabilities.
Book value can also represent the value of a particular asset on
the company's balance sheet after taking accumulated depreciation into
account.
This is determined by the use of standardized accounting technique and
is calculated from the financial reports particularly the balance sheet.it
is usually fairly close to its par or face value.
***
3. Replacement value:The term replacement cost or replacement
value refers to the amount that an entity would have to pay
to replace an asset at the present time, according to its current worth. In
the insurance industry, "replacement cost" or "replacement cost value"
is one of several method of determining the value of an insured item.
4. Liquidation Value: The net amount that can be realized if the
business is terminated and the assets are sold. There are two types
namely, orderly liquidation and forced liquidation. Liquidation value is
the likely price of an asset when it is allowed insufficient time to sell on
the open market, thereby reducing its exposure to potential
buyers. Liquidation value is typically lower than fair market value.
The seller is under extreme compulsion to sell. The buyer is typically
motivated.
***
5. Goodwill value: The amount of goodwill is the cost to purchase the
business minus the fair market value of the tangible assets, the
intangible assets that can be identified, and the liabilities obtained in the
purchase. In order to calculate goodwill, the fair market value of
identifiable assets and liabilities of the company acquired is deducted
from the purchase price.
For instance, if company A acquired 100% of company B, but paid more
than the net market value of company B, a goodwill occurs.
6. Salvage value: It is the estimated resale value of an asset at the end of
its useful life. It is subtracted from the cost of a fixed asset to determine
the amount of the asset cost that will be depreciated. Thus, salvage
value is used as a component of the depreciation calculation. It appears
on a company’s B/S .
***
7. Going concern value: It is the value of a business that is expected to
continue to the future. The value of the securities of a profitable
,operating firm with prospectus for indefinite future business might
expressed as going concern value. The worth of the firm would be
expressed in terms of the future profits, dividends or growth of the
business. It takes into account various intangible assets of the
organization. It is also known as total value.
8. Insurable value: Insurable value is the value of destructible portion of
an assets that requires to be insured to indemnify the owner in the event
of loss. Post –acquisition review of insurance coverage of property can
be done with little impact on the valuation.
*1*0*. Intrinsic value: It is the anticipated or calculated value of
a company, stock, currency or product determined through
fundamantal analysis. It includes tangible and intangible
factors. real value may or may not be same as the current
market value. Basically, it is the present value of future
earnings discounted at current market yield.
• It is ordinarily calculated by summing the discounted
future income generated by the asset to obtain the
present value.
•A security's intrinsic value is the price that is justified for it
when the primary factors of value are considered.
Objectives of corporate valuation
• Main objectives of corporate valuation are to:
i. Assist a purchaser or seller in deciding the acceptable purchase
consideration
ii. Assist an arbitrator in settling a dispute between parties
iii. Assist a lender in quantifying the security for loan
iv.Establish value for stamp duty
v. Quantify a value for inclusion of accounting records
vi. Assess a consequential loss claim
vii. Assess a management buyout or a leveraged buyout
Price and value differentiation
• Price is what one pays and value is what he receives. Price is
the valuable consideration for which a thing is bought and
sold. Most of the time, price and value differ indicating
differences in perception between buyers and sellers.
• The purchasers is unaware of the availability of the assets or
the buyer believes that the price is lower than the worth of the
assets.
• It is suggested that depending upon the purpose of valuation,
quoting a range of values rather than a single value of
business or assets would be appropriate.
Sources of information for valuation
• The following important sources of information for valuation are:
i. Annual reports and audited accounts of the company or the business
being valued.
ii.Management account of the same
iii.Reports of future prospects operational results, cash flows, board
discussion papers, review documents after discussion with senior
management
iv.Relevant economic data and industries statistics
v.Stock market statistics.
vi. Publicly available information like press release, media reports
vii.Industry journals, surveys, and the like
Valuation process
• Valuation is a process of an appraisal or determination of the
value of certain assets or properties, business ownership
interest, and so on, as on a specific date.
A competent valuation satisfies two conditions:
1. It reaches an accurate value conclusion.
2. It clearly and convincingly establishes how value conclusion
is reached.
A good business valuation can be successfully defended and
supported under critical scrutiny.
Steps of valuation
Steps of valuation procedure are:
1. Valuation by independent valuer: This process is carried on the assets
and liabilities for the respective state owned enterprises (SOEs) that are
prepared by enlisted valuer of the firm.
2. Review of the Valuation Committee: In this the valuation report
submitted by the valuer enlisted firm is examined by the Valuation
Committee that includes the Ministry of Finance and the Concerned
Board of the company.
3. Re valuation: After reviewing the report by the Committee, it is again
send for revaluation, in case of discrepancy. Otherwise it is treated as a
final report.
***
4. Valuation Report and Enterprise Profile: After finalization, tenders are
invited. Valuation report and Enterprise Profile can give the entire
information about the enterprise.
•Valuation can be done on assets such as stocks, options, business
enterprises or intangible assets such as patents or trademarks. Valuation
method determines the current worth and therefore is used to quantify in
terms of monetary terms considering its benefits.
Valuation methods are generally of three types:
•Approaches that are based on the principle of substitution and consider
sum of all business investments (cost approach), sum of all future
benefits (income approach), or valuation by comparing it with the value
of similar assets or businesses (market approach).
***
Value creation
• Business success comes from value creation for owners,
customers, and employees. Value is being built or destroyed
throughout our business. Value creation is the starting point
or the primary aim of any business entity. Creating value for
customers helps to sell products and services, creating value
for employees results in higher efficiency and creating
value for shareholders, in the form of increases in stock price,
future gurantee of investment capital to fund operations.
• In financial terms, this means creating revenue which
exceeds expenses which results in a profit, or value to
the stakeholders. A broader definition includes creating value
for the customer to increase sales, and to create perceived
Different approaches
• Valuation Methods used for determining value of different assets is
briefly given below:
• Fixed Asset Valuation methods: Cost method, Market Value method,
Base Cost method, Standard Cost method, Average Cost method etc.
• Inventory Valuation methods: First in First Out method, Last in First
Out method, Weighted average method (as allowed by GAAP)
• Business Valuation method: Asset-bases approaches, Earning value
approaches such as Discounted Cash Flow method and current
Market Value approaches (by comparing with similar businesses).
CORPORATE VALUATION
Corporate valuation is the process of determining the economic
worth of a company based on its business model and external
environment and supported with reasons and empirical evidence.
Corporation valuation is a process and a set of procedures used
to estimate the economic value of an owner's interest in a business.
Valuation is used by financial market participants to determine
the price they are willing to pay or receive to perfect the sale of a
business .
***
This valuation depends upon the following basic concept are :
a. Purpose of valuation-dividend, M&A etc.,
b. Stage of business -life cycle of the business
c. Past financials -previous performance, strenth &weakness
d. Expected financial results-projetion for the future
e. Industry scenario-e.g COVIT-19
Valuing of the business Vs valuing the company
• Valuing the company mean all assets including intellectual
properties(if relevant and having revenue potentials) reduced by
liabilities. Valuing the business means capitalization of the future
earning potentials after considering internal and external business and
economic environments. For going concern, valuation of business will
essentially lead to valuation of the company.
• Under simple accounting concepts, the net asset of the enterprise is
nothing but the value of the company at its present ownership of
properties. The value of the company is given by (assuming no
preferential capital):
• Vc=FA+(CA-CL)=Ve+Vd, where Vc –total value of the company,
Ve-Value of equity, Vd-value of debt(long term)
***
• Therefore, equity value (Ve) =Vc-Vd
• In case of debt free company Ve=Vc. Depending upon the purpose,
either Ve or Vc is estimated. e.g Reliance debt free company.
• In the case of M&A deal, where exchange ratio of share of two
companies is agreed upon, Ve is more significant than Vc.
Again, in the case of an all cash deal, Vc is more significant than Ve.
The total value of a company (Vc) has a relation with its future
business potential which is the discounted present value of future free
cash flows( cash left over after a company pays for its operating
expenses and capital expenditure) on a going concern basis.
Value creation through RRR
• The required rate of return is a key concept in corporate
finance and equity valuation.
• Required rate of return (RRR) is the minimum amount of
money that an investor expects to receive from an investment.
This amount takes into account several factors such as the
amount of risk involved, inflation, liquidity and the duration
of the investment.
• The required rate of return is the minimum return an investor
expects to achieve by investing in a project. An investor typically sets
the required rate of return by adding a risk premium to the interest
percentage that could be gained by investing excess funds in a risk-
free investment.
 Factors influenced by RRR
The required rate of return is influenced by the following factors:
•Risk of the investment. A company or investor may insist on a higher
required rate of return for what is perceived to be a risky investment, or
a lower return on a correspondingly lower-risk investment. Some
entities will even invest funds in negative-return government bonds if
the bonds are perceived to be very secure.
•Liquidity of the investment: If an investment cannot return funds for a
number of years, this effectively increases the risk of the investment,
which in turn increases the required rate of return.
•Inflation: The required rate of return must be layered on top of the
expected inflation rate. Thus, a high expected inflation rate will
drastically increase the required rate of return.
***
• The required rate of return is useful as a benchmark or
threshold, below which possible projects and investments are
discarded. Thus, it can be an excellent tool for sorting
through a variety of investment options.
• The required rate of return is not the same as the cost of
capital of a business. The cost of capital is the cost that a
business incurs in exchange for the use of the debt, preferred
stock, and common stock given to it by lenders and investors.
• The cost of capital represents the lowest rate of return at
which a business should invest funds, since any return below
that level would represent a negative return on its debt and
equity.
***
• The required rate of return should never be lower than the
cost of capital, and it could be substantially higher.
• The level of the required rate of return, if too high, effectively
drives investment behavior into riskier investments.
For example:
• 3% rate of return would allow one to invest in a variety of
low-risk opportunities, whereas a 15% rate of return would
likely eliminate the lower-risk options, leaving an investor
with a much smaller number of higher-risk alternative
investment opportunities.
***

• The required rate of return is a key concept in corporate

finance and equity valuation. For instance, in equity
valuation, it is commonly used as a discount rate to determine
the present value of cash flows.
• For example:
a.NPV,
b.IRR
c.Risk adjusted discount rate
d.Certainty equivalent cash flows methods etc.,
Intrinsic value
Intrinsic value is a measure of what an asset is worth. A security's
intrinsic value or real worth of the debt or equity instrument as distinguished
from the current market price. The financial manager estimates intrinsic value on
the following fundamental factors that affect security values.
i. Value of the Firm's Assets- The physical assets held by the firm have some MV.
They can be liquidated if need to provide funds to repay debt and dividend to
SH's. In techniques of going concern valuation, asset values are usually omitted
ii. Likely Future Interest and dividends- The firms make an attempts to declare
dividend and interest in future. The Likelihood of these payments affects present
value.
iii. Likely Future Earnings- Expected future earnings is an important factor, without
reasonable level of earnings, interest and dividend payments may be in
danger/loss.
iv. Likely Future Growth Rate- A firm's prospects for future growth carefully
evaluted by investors and Crs which are influencing intrinsic value.
Intrinsic value analysis
The process of comparing the real worth of a secutity with
current market price or proposed purchase price. The primary goal of
intrinsic value analysis is to locate clearly undervalued or overvalued
firm's or stocks.
eg If undervalued security - market has not discovered fundamental
factors that justify higher market price i. e the security worth more
than its selling price. Mgt announces higher EPS than expected,
investor will buy the stock & force to raise price and firm's or
individuals purchased stock when it was undervalued would profit.
If Overvalued stock, the reverse situation.When investors holding
stock discover that it is overvalued, they will sell their share, causing
a drop in the market price.It is thus to avoid purchasing overvalued
stocks.
***
It is applied mostly to common stock, it is equally valuable for
analysing bonds and preferred stock. By using intereast rate levels or
dividend levels, the analyst find Intrinsic value for the fixed return
security.
This value would be compared to the actual market price of the
secutity in order to determine whether the security was undervalued,
properly valued or overvalued.
* When IntrinsicValue is greater than MP that means stock is
undervalued &investors will look an opportunity to buy and vice-
versa i.e MP is greater than I/V is overvalued and it is not the good
time to invest in it.
Required Return on Securities
i. Cost of debt,ii. Preferred stock & iii.Common stock)
i. Cost of debt(before tax)
Ki= I /MV, where, I – Annual interest before tax,
MV-Market Value of debt/Net proceeds

Annual Interest need to pay Rs. 3,50,000:

Market value of debt Rs. 35,00,000.
What is the cost of debt before tax?
= 3,50,000/ 35,00,000 =0.10 i.e 10%
ii. RRR on preferred stock

Pref. stock do not offer the firm a tax shield, as the case with interest payments,
we solve directly for after tax required return on pref stock
The formula is :
= Dividend /MV where , MV-market value of the stock
As an example, $100 par value of preferred stock is selling for $ 120. The
firm declares dividends at the 14 per cent stated rate for the preferred stock
issue. What is RRR?
The required return on the stock is :
= D/MV
= ($100X.14)=14=D
= 14/ 120= 0.11666
RRR= 11.7%
iii. RRR on common stock
Determining R/R on common stock greater difficulties than the known
value for pref. stock /debt. The common shareholders does not expect to
receive any fixed, predetermined return, rather, the shareholders
receives the right to participate in sharing future earnings and cash
dividends.
To recognize these rights, the return on equity capital must note factors
such as earnings, dividends, growth rate and market price of the
common stock.We identify for valuation- the going concern value and
differ with liquidation value that would be received among the
shareholders. Going concern value depends upon future net cash flows
to the shareholders.
The WACC approach assumes a going concern foundation and uses
flows as the measure of return on common stock.
Capitalization technique
A capitalization techniques is a method of converting future cash flows
into a single present or intrinsic value for a security.
For example, for debt and fixed return securities, we have been
capitalizing future interest or dividends. The same process is followed
for common stock,with a single perception. The common stock offers
the potential for growth of future cash flows, and this must be
reflected in the intrinsic value analysis.
In this section, we will develop approaches to the valuation of common
stock.
i. Single-Period Model(ROR): The rate of return on an investment may
be expressed for one year, normally a year. Any cash received during
the year plus any increase in value from the investment.
***
E(rtn)= Val 1- Val 0+cash/Val 0,
where, E(rtn)-rate of return earned in period 1,
Val 1= ending value of the security at the end of period 1
Val 0= starting value at point 0
Cash1= any cash received between point 0 and the end of period1
Example:An investor purchases 100 share of common stock for Rs
4,000 plus a 100 commission. In a single year, he sells the stock for
Rs. 4,500, less a Rs 100 commission. During the year, he received
Rs.250 in dividend.
What was the rate of return?
E(rtn)=4400-4100+250/4100 =300+250/4100 =.134 0r 13.4%
PV under single -period model
Cal. Present value of a share of common stock expressed under single
period model- the formula to solve for (Val 0):
Val0=1/1+Ke(req) X (Div1+val1)
= (Dividend =cash received +Val 1(end value is given)
Example: In a 1 year, 100 shares of common stock will be worth a total
of Rs.7000.During the year, the holder of the shares will receive
dividends of Rs.500. Investment in this kind of stock require an 11 %
return before taxes.
What is the intrinsic value of the 100 shares?
Val0= 1/1+.11(500+7000)= Rs. 6,756.76
ii. Perpectual dividend, No growth
Second approch at more than one period:
A firms that will not grow in terms of earnings or dividends.
We use the formula: Val 0= DPS/Ke(req)
DPS - in period 1 and every future period of the firm's dividend are not growing.
The growth may be expressed by the formula:
Val 0=DPS/Ke(req)
It should note that dividends equal earnings for a firm that is not growing.
Required return may be expressed by the formula
g= EPS/MV(%RE)
Growth rate to be 0, the percent of RE must be Zero.
Thus, all EPS is paid out as DPS & the value of the stock can be expressed as :
Val 0= DPS/Ke(req)= EPS/Ke(req)
iii. Perpetual dividends, constant growth
Third approach considers a situation where earning and dividends are
growing at a constant rate. In this situation, the firm retains a portion
of its earnings to finance growth but maintain a constant dividend pay
out, which is the relationship between dividends and earnings or
Dividend payout .
Dividend payout = DPS/EPS
Under the assumption of a constant growth rate, the intrinsic value
is a function of a infinite stream of steadily growing dividends.
The valuation formula is:
Val 0= DPS or EPS/Ke(req)-g ( Gordon model)
Example
A firm has an earnings per share of $5 and a dividend payout of 44 per
cent . An investor requires a 16 per cent return on this kind of stock.
The growth rate equals 12 per cent.
What is the intrinsic value of the stock?
Val 0=EPS
Ke(req)-g

Val0 = 5X .44
.16-.12 = $55
***
This measure of growth does not consider funds raised by
additional borrowings or sale of stock. It uses only retained earnings to
finance WC, P&M and other assets that would be needed by the firm as
it grows.
Only the retention of earnings will produce growth in dividends for the
firm’s existing shareholders without change in the financial risk from
debt or sale of stock.
• Now that we have defined growth rate, we can return to our formula
that discounts an indefinite stream of dividends.
Current market value approach
The second technique of security valuation considers the price of
individual stocks compared to other indicators in the market place. If the
analyst believes that a security is worth more in terms of market value
than asking price, purchasing it is recommended.
The current value approach deals simply with prices in the market, not
with issues of intrinsic value. Three short term factors are of primary
concern;
1. Depressed overall market: Investor can make purchase only when the market
appears to be at a low for most stocks. Rational for this technique current MV
below a normal current MV
2.Industry comparison: A firm or investors will seek purchases that seem to be
bargains compared to other firms in the industry. This might occur when similar
stocks have risen in price while the stock of one firm has lagged behind for no real
reason. This is the case of a single firm's current market price below it near-term
value.
Current market value approach(CMV)
A number of securities have market prices that
3. Cyclical lows:
follow a cyclical pattern.
Eg. A stock may rise to $ 50 a share, and then
institutional and other investors may decide to sell it and
accept some profits. The selling pressure may force it down to
$30 per share, at which point the investor might again to buy
shares. The analyst would then purchase the security near
cyclical low and attempt to sell it near a cyclical high.
Both Intrinsic & CMV methods are concerned with
locating undervalued and overvalued stocks and seeking
securities that offer high value for the price paid for them.
ntrinsic Value and Current Market Value Analysis – Key Points

1. Intrinsic Value Analysis

• Definition: Intrinsic value is the true worth of a security, compared to its market price or proposed purchase price.
• Goal: Identify undervalued or overvalued stocks to make profitable investment decisions.
Key Scenarios:
• Undervalued Security:
o Market has not recognized its true value.
o Investors buy, driving the price up, yielding profits.
• Overvalued Security:
o Price exceeds intrinsic value.
o Investors sell to avoid losses, causing price drops.
Application:
• Common stocks, bonds, and preferred stocks:
o Compare intrinsic value (using interest or dividend levels) with market price to assess valuation.
o If Intrinsic Value > Market Price: Buy.
o If Intrinsic Value < Market Price: Avoid investing.
2. Required Return (RR) for Securities
The required return is the minimum return investors expect for investing in a security, based on its type and risk. Here's how
it's calculated for different securities:

a. Debt (Before Tax)

• Formula:
RR (Ki)=Interest (I)Market Value (MV)\text{RR (Ki)} = \frac{\text{Interest (I)}}{\text{Market Value (MV)}}
• Explanation:
This shows the percentage return from the interest paid on the debt compared to its current market value.
• Example:
If the annual interest on a loan is ₹3,50,000 and its market value is ₹35,00,000, the required return is:
3,50,000÷35,00,000=10%3,50,000 \div 35,00,000 = 10\%.
b. Preferred Stock
• Formula:
RR=Dividend (D)Market Value (MV)\text{RR} = \frac{\text{Dividend (D)}}{\text{Market Value (MV)}}
• Explanation:
This shows how much return investors get from the dividends compared to the stock's market price.
• Example:
A preferred stock with a ₹14 dividend is selling for ₹120:
14÷120=11.7%14 \div 120 = 11.7\%.

c. Common Stock
• Explanation:
Calculating required return is more complex because there’s no fixed return. Investors expect profits from:
o Dividends.
o Share price growth (capital gains).
The return depends on earnings, dividend payout, growth rate, and share price.

3. Capitalization Techniques
These methods convert future cash flows into a present value to determine the security's worth today.

a. Single-Period Model
• Formula:
Return (E(rtn))=End Value (Val1)−Start Value (Val0)+Cash ReceivedStart Value (Val0)\text{Return (E(rtn))} =
\frac{\text{End Value (Val1)} - \text{Start Value (Val0)} + \text{Cash Received}}{\text{Start Value (Val0)}}
• Explanation:
Calculates the return for one year, combining cash (dividends) and changes in stock price.
• Example:
o Buy stock for ₹4,000, sell it for ₹4,500.
o Receive ₹250 in dividends.
o Return = (4,500−4,000+250)÷4,000=13.4%(4,500 - 4,000 + 250) \div 4,000 = 13.4\%.
b. No Growth (Perpetual Dividends)
• Formula:
Val0=Dividend Per Share (DPS)Required Return (Ke)\text{Val0} = \frac{\text{Dividend Per Share
(DPS)}}{\text{Required Return (Ke)}}
• Explanation:
For companies that don’t grow, all profits are paid as dividends. The value of the stock depends only on the dividend and
required return.

c. Constant Growth (Gordon Model)

• Formula:
Val0=EPS×Dividend PayoutKe−g\text{Val0} = \frac{\text{EPS} \times \text{Dividend Payout}}{\text{Ke} - g}
• Explanation:
For companies with steady growth, stock value depends on dividends, growth rate, and required return.
• Example:
o EPS = $5, Dividend Payout = 44%, Growth = 12%, Required Return = 16%.
o Value = \frac{5 \times 0.44}{0.16 - 0.12} = $55.

These methods help investors estimate the fair value of a stock based on expected cash flows, making it easier to decide
whether to buy, sell, or hold.
Current Market Value (CMV) Approach
• Focuses on current prices and comparisons in the market rather than intrinsic value.
Techniques:
1. Depressed Market:
Buy during market lows when most stocks are undervalued.
2. Industry Comparison:
Identify undervalued stocks compared to peers with no valid reason for the price lag.
3. Cyclical Lows:
Buy stocks at cyclical lows and sell near cyclical highs (e.g., buy at $30, sell at $50).
GORDON MODEL
The Gordon model is also known as dividend discount model/Constant
growth model ie. Unchanging rate. This model equates this value to the
PV of a stock’s future dividends:
Assumptions :
i.The firm is an all-equity
ii. Business model stable
iii. No significant changes in its operation
iv. Grows at a constant rate
i.e Rate of return and cost of capital are constant .
v. No external finance i.e only retained earnings are used to finance
investments.
Factors incorporate in the Gordon model
Three primary factors should be noted in terms of the construction of
the Gorden Model.
i. Shareholder's Return -Single Variable- In the single -period model, the
return to the SH's consisted of Dividends and Capital gains. But this
is not the case with the Gorden model. SH,s Return soley of future
dividends. Earning retained by the firm are part of the growth factor
that will operate to increase dividends but future dividends are viewed
as a return.
ii. Normal and actual returns: Gordon model built upon comparison of a
Normal or Required Return and an Actual Return.
These are
a. Required return(Ke), b. Actual return ***
***
a. Required Return (Ke): Given risk &return charateristics of the stock,
the market will require some ROE. This is expressed by EPS/MP as
required by the investor in similar stocks. Since, this is the reciprocal
of the P/E ratio i.e Share Price/EPS - below or lower than 20%
(undervalued stock) is good -more opportunities of attractive
investment), it is used to find out whether they are overvalued or
undervalued. Commonly it is expressed in terms of a ormal P/E
multiple. We can compare it to the average P/E of the competitors
within its industry.
b. Actual Return: This is the actual EPS/MP for the individual firm. It is
included as a part of growth factor, since g equals EPS/MP times the
percentage of R/Es.
In short, The difference between RR&AR has a significant impact
on the value of the stock.
***
iii. Inclusion of a Growth factor: In order to take long term view point,
the model assumes steady growth of dividends and includes a factor
to incorporate such growth into the valuation formula.
Growth is restricted to R/Es.The sale of addtional stock or growth
from increasing the amount of debt or other return on securities is
ommited.
The impact of growth variable can be rewritten :
Intrinsic value = Div1
Ke(req)-(Ke(act)(%RE),
where, Div1-Current dividend, Ke(req) Normal or RRE demended by
the market for a stock of this risk level, Ke (act)-Actual ROE for the
firm, %R/E -percentage of EPS that the firm is likely to retain in the
future.
Example
Comparing the Intrinsic value(I/V) with Gordon Model under
different return and Dividend payouts. To understand it fully, we must
examine the effect of changing the dividend payout under different
situations with respect to the ROE. Let us consider a company with
an EPS Rs 2 and Actual ROE of 10%. There are 3 possible situations”
i. Required Return(RR) less than Actual Return(AR): The stockholder is
gaining more earnings by investing in the company than required
from this risk level.
e.g: A 8% return may be required, and the firm is actually achieved a
10% return on them. If SHs want to the firm to retain earnings &
achieve a 10% return on them. If dividends are paid, the investor can
probably only 8% or so from the similar investments. Thus, we
would expect that raising the dividend pay out would lower Intrinsic
value, since it lowers the growth rate of a highly profitable firm. (see
*ii.*R*R equal to AR: In this case, the firm is doing about as well as
expected, and the SH's probabily does care about the level of
dividends. If they are declared, they will be reinvested in the firm or
in a similar firm. We would expect that I/V would be in unaffected by
the level of dividend payouts.
(see table I/V of $20 at all payout when the firms earns what is
required)
iii. RR exceeding AR: The firm is not doing as well as expected.
Overall, I/V will be less than for a firm doing as well as required. But
we expect the I/V to raise if the firm increased its dividend payout,
since the SH's would like to have cash to invest at a higher return
elsewhere.(see table I/V increses from $12 to $16.67 when payout
increased fom 30% to 100%)
*** Changing dividend payout has different results, depending upon
the relationship between actual and required return.
(see material/ Refer whatsapp message)
A firm that is doing better than required has a higher I/V than a
firm doing -worse. The firm is encouraged to retain its earnings and
reinvest them at the actual rates that are higher than required for the
given risk level.
Key Factors in the Gordon Model – Summary
The Gordon Model focuses on valuing a stock based on future dividends, incorporating shareholder returns, growth factors,
and the comparison of required vs. actual returns.

1. Shareholder Returns:
• Focus on Dividends:
The model assumes shareholder returns come solely from future dividends, not from capital gains or retained earnings.
• Growth Role:
Retained earnings contribute to future dividend growth, enhancing long-term returns.

2. Required and Actual Returns:

• Required Return (Ke):
o Reflects market expectations for returns based on stock risk.
o Calculated as EPS/MP, the reciprocal of the P/E ratio.
o Helps identify undervalued or overvalued stocks (e.g., low P/E often signals undervaluation).
• Actual Return (AR):
o Reflects the firm's actual EPS/MP.
o Includes the growth factor as it depends on retained earnings.
• Impact on Value:
The difference between Ke and AR significantly affects the stock’s intrinsic value.

3. Growth Factor:
• Assumes steady dividend growth from retained earnings, ignoring external financing (e.g., debt or new stock issuance).
• Formula:
Intrinsic Value (I/V) = Div1 / [Ke(req) - Ke(act)(%R/E)], where:
o Div1: Current dividend.
o Ke(req): Required return.
o Ke(act): Actual ROE.
o %R/E: Percentage of EPS retained.
4. Impact of Dividend Payout on Intrinsic Value (I/V):
• Scenario 1: Required Return < Actual Return
o Retained earnings yield a higher return than the market requires.
o Higher retention = higher I/V (lower dividend payouts are preferred).
• Scenario 2: Required Return = Actual Return
o Firm meets market expectations.
o I/V remains unaffected by dividend payout levels.
• Scenario 3: Required Return > Actual Return
o Firm underperforms market expectations.
o Higher dividends increase I/V, as shareholders prefer cash for higher-yielding investments.

Key Insight:
Firms exceeding required returns should retain earnings to maximize growth, while underperforming firms should prioritize
dividends to satisfy shareholder expectations.
Comparative approaches to valuation
To analyst will seek the I/V by comparing one frim with others.
Similar operating charateristcis and risk have similar I/V :
We examine three comparative approaches to determine
I/V .
1.Comparing Price Earnings multiples
2.Comparing value with Gordon Model
3.Relationship of book value and market value
1. Comparing Price Earnings multiples
Many analyst-rely on this-as determine I/V . The
effect, they seek to capitalize earnings using formula:
Intrinsic value =EPS/Ke(req),
which is a Variation of the formula=
Ke=EPS/MP,
where I/V replaces the Market price, once the
formula accepted, the analyst can observe the reciprocal
of EPS/MP or the price earnings multiple for the stocks of
publicaly traded stocks in order to determine the value of the
privately held securities.
****
Is this a valid method?
The answer is Yes within a very restricted scope.
Suppose an anlayst is valuing privately traded stock. further
suppose that the private company is similar to the publicly
traded company in terms of risk, profiability, and growth
rate.
In this situation, the publicly traded stock's price earnings
multiple could be used as a proxy for the intrinsic value of
the privately held stock.
For example;***
 Example 1
Let us consider Firm A (privately owned) and has a Rs
4 EPS, Firm B &C are similar risk and return, and they are
traded publicly at a 7/1 price earning multiple.
What is the value of Firm A?
If the reciprocal of the price earnings multiple (1/7) is used as the
required return, the I/V is Rs 28 =(7/1X4)
Ke(req)= EPS/MP=1/7=.1429
Intrinsic value =Rs4/.1429=28 Rs
or The same answer can be obtained by multiplying the observed
price earnings multiple by the EPS , or =7X4=Rs.28.
ii. Comparing value with Gordon Model
The Gordn Model can be used to compare values if we make a single
important assumption. We must assume that the MP of similar firms is also the
I/V of the firms, when this is done, the formula becomes
MP= Div/Ke(req)-(Ke(act)(%RE)
This formula has four components : MP, Current dividend, growth rate, and
the Required return on equity. For similar, publicly traded firms , the first three of
these components are known. We can modify the formula to solve for the
required return on equity.
Ke(req)=Div1 +(Ke(act))(%RE)
MP
Once we have the required rate of return on equity for similar firms, we can apply it to the
firm being valued. since privately owned firm pay dividends. We can use the dividend, growth
rate (actual Ke times % of RE) and required rate of return on equity to determine the probable MP
if the stock were traded. Then we can assume that this would probably be close to the I/V.
Example
By using this technique, a privately held firm has a 5 per cent growth
rate and pays a $ 6 dividend. A similar firm is publicly traded at $ 80
per share, pays $ 4 dividend, and has an 8 per cent growth rate.
What is the value of the privately held firm?
the Required return on equity is
Ke(req)== Div1 +(Ke(act))(%RE) (or Growth Rate)
MP
i.e growth rate (actual Ke times % of RE)
Ke(req) = 4/80 +.08=.13, the expected MP, and intrinsic
value, of the privately held firm is MP=Div/Ke(req)- Growth rate i.e
(Ke(act)(%RE) Market price=I/V= $6/.13-.05=$7 5
Example
Companies Q,R and S are in the same basic industry and offer
similar risk and return. Company Q sells for $18 per share, pays a $
1.50 dividend, and has a 5 % growth rate. Company R sells for $36
per share, pays a 2.50 dividend, and has a 7 % growth rate. Company
S is privately owned, pays an $8 dividend, and has a 9 % growth rate
What is the value of company S?
The Require Return on equity for Q and R can be calculated
For Q: Ke(req)= 1.50/18+0.05=.13
For R: Ke(Req) = 2.50/36+.07=.14
Since company S is similar, we might use the average required reurn,or
13.5%(13+14).
The value of S is thus: I/V = 8/.135-0.09=$178
iii. Relationship of book value and market value
• Book value of a firm can not used directly to determine the market or
intrinsic value of going concern, similar firms may have similar ratios
of market value to book value. t is, if two similar firms have a 40
percent ratios of book to market value, this knowledge may be helpful
in estimating the market value of a third similar firm that is privately
held.
• E.g, A publicly traded firm Thahas a book value of $30 per share and a
market price of $45 per share . What is the intrinsic value of a similar
firm with a $10 book value per share?
• Since one firm has a 30/45 or 2/3 = 0.667 , ratio of book value to
market price, then second firm might be worth: $10/.667 = $15
Example
Companies X,Y, and Z are similar in risk and return. Company
Z is privately held. Company X has a market price of $80 and
a book value of $60. Company Y has a market price of $20 and
a book value of $ 14 . Company Z has a book value of $40.
What is the possible Market value of Z? i.e BV/MV
For company X, the ratio of book to market value is 60/80, or
75 percent. For company Y, the ratio is 14/20 or 70 percent, for
company Z, dividing the $40 book value by.70 and .75,
we get a range of value from $ 40/.70=$57.143 and
$40/.75=$53.334 ie. $53 to $57.
Net assets valuation Model
• One of the most common ways to determine the value of a company is
called the asset-based method that uses the book value of a company’s
equity. In other words, it determines the value of the company’s assets
minus its debts.
• Regardless of whether it’s tangible items, such as cash and working
capital, or intangible things, such as brand name and reputation, equity
is the most important factor. Equity is everything that a company
possesses if they were to suddenly stop doing business and making
money.
• The value of the company is given by
Vc =Ve+vd =FA+(CA-CL)+Vi-Vr
Comparative Approaches to Valuation – Key Points Summary
1. Purpose:
Valuation is done by comparing a firm with others having similar risk and operating characteristics.

1. Price-Earnings Multiples:
• Formula:
Intrinsic Value (I/V) = EPS × Price-Earnings (P/E) Multiple.
• Application:
Use the P/E ratio of similar publicly traded firms to estimate the value of privately held firms.
• Example:
Firm A (EPS = ₹4), similar firms have P/E = 7.
I/V = ₹4 × 7 = ₹28.

2. Gordon Growth Model:

• Formula:
MP = Div / (Ke - g), where:
o Div: Dividend.
o Ke: Required return on equity.
o g: Growth rate.
• Application:
Use publicly traded firms’ data to calculate Ke and estimate the value of private firms.
• Example:
Firm S pays an $8 dividend, growth rate = 9%, Ke = 13.5%.
I/V = $8 / (0.135 - 0.09) = $178.

3. Book Value and Market Value Relationship:

• Approach:
Compare the ratio of book value to market value (BV/MV) of similar public firms to estimate the market value of private firms.
• Example:
Company Z (BV = $40), similar firms have BV/MV ratios of 0.70 to 0.75.
Estimated MV = $40 / 0.70 to $40 / 0.75 = $53 to $57.

Net Assets Valuation Model:

• Formula:
Company Value = Fixed Assets + (Current Assets - Liabilities) + Intangible Assets - Redundant Assets.
• Use:
Focuses on the equity (assets minus liabilities) to estimate the firm’s worth.
This concise summary simplifies the key concepts and formulas for practical use.
 Discounted cash flow model(DCF)
• Discounted cash flow (DCF) is a valuation method used to estimate the value of
an investment based on its future cash flows. DCF analysis attempts to figure out
the value of a company today, based on projections of how much money it will
generate in the future.
• DCF analysis finds the present value of expected future cash flows using a
discount rate. A present value estimate is then used to evaluate a potential
investment. If the value calculated through DCF is higher than the current cost of
the investment, the opportunity should be considered.
• The purpose of DCF analysis is to estimate the money an investor would receive
from an investment, adjusted for the time value of money. The time value of
money assumes that a dollar today is worth more than a dollar tomorrow.
• For example, assuming 5% annual interest, $1.00 in a savings account will be
worth $1.05 in a year. Similarly, if a $1 payment is delayed for a year, its present
value is $.95 because it cannot be put in your savings account.

Discounted Cash Flow (DCF) - Key Points Summary:

1. Purpose:
DCF estimates the current value of an investment based on its future cash flows, adjusted for the time value
of money.
2. Calculation:
o Projects future cash flows.
o Discounts them to their present value using a discount rate.
o Compares the result to the investment's cost.
3. Decision Rule:
o If the DCF value is higher than the investment cost, it’s a good opportunity.
4. Time Value of Money:
A dollar today is worth more than a dollar in the future (e.g., $1 today earns interest and grows).
Thank you

END of II unit ****

 Mind Map: Corporate Valuation Overview

1. Concept of Value
• Definition: Monetary worth of a business or asset.
• Types of Value:
o Fair Market Value: Price agreed by informed buyer and seller.
o Book Value: Assets - Liabilities (on the balance sheet).
o Replacement Value: Cost to replace an asset today.
o Liquidation Value: Value during forced or orderly sale.
o Goodwill: Price paid above tangible asset value in acquisitions.
o Going Concern Value: Expected future profits from an operating business.

2. Objectives of Corporate Valuation

• Determine fair purchase or sale price.
• Assist in M&A, disputes, loans, or buyouts.
• Assess losses, record valuations, or establish tax obligations.

3. Valuation Approaches
• Fixed Assets: Cost, market, or average cost methods.
• Inventory: FIFO, LIFO, or weighted average methods.
• Business Valuation:
o Asset-based: Equity = Total Assets - Liabilities.
o Earnings-based: Discounted Cash Flow (DCF), Market Value.

4. Intrinsic Value
• Definition: True worth based on fundamentals like future earnings and dividends.
• Application: Compare intrinsic value with market price:
o If Intrinsic > Market Price: Undervalued (Buy).
o If Intrinsic < Market Price: Overvalued (Avoid).
 5. Discounted Cash Flow (DCF) Model
• Purpose: Estimate present value of future cash flows using a discount rate.
• Decision Rule:
o If DCF > Investment Cost: Good investment.
• Key Factor: Time value of money (money today > money tomorrow).

6. Gordon Model (Constant Growth)

• Formula: Value=DPSKe−g\text{Value} = \frac{\text{DPS}}{\text{Ke} - g}.
• Assumes steady dividend growth and no external financing.

7. Required Return on Securities

• Debt: RR=InterestMarket Value\text{RR} = \frac{\text{Interest}}{\text{Market Value}}.
• Preferred Stock: RR=DividendMarket Value\text{RR} = \frac{\text{Dividend}}{\text{Market Value}}.
• Common Stock: Harder to calculate due to variable returns (growth, dividends).

8. Comparative Valuation Approaches

• P/E Multiples: Compare similar public firms’ P/E ratios.
• Book to Market Ratio: Use BV/MV ratio of peers to estimate private firm value.

9. Capitalization Techniques
• Convert future cash flows into present value.
o Single-Period Model: Focuses on returns in one year.
o Constant Growth: Includes growth rate in valuation.

10. Current Market Value (CMV)

• Key Factors:
o Depressed market conditions.
o Industry comparisons.
o Cyclical price lows.