Valuation Principles – NISM Series XV Research Analyst Short Notes (Part 10)
This is Part 10 of the NISM Research Analyst Short Notes series on PassNISM.in. Valuation is the core skill that separates a good research analyst from an average one. This chapter covers the difference between price and value, all major valuation approaches, discounted cash flow models, relative valuation multiples, CAPM, and the sum-of-parts method.
Valuation questions — especially calculations involving Gordon Growth Model, PE, EV/EBITDA, PEG Ratio, and CAPM — are very frequently tested in the NISM Series XV exam.
Price vs Value — The Foundation of Investment Thinking
Price is the current market price of a security — publicly available and known to all at any given moment.
Value is the analyst's estimate of what the security is actually worth, based on analysis of the underlying business. Value is subjective and depends on the assumptions and methodology used.
The fundamental premise of active investing is that price can deviate from value. When price is below intrinsic value, the security is undervalued and represents a buying opportunity. When price exceeds intrinsic value, the security is overvalued and may be a selling opportunity.
Three Approaches to Valuation 1. Cost-Based Valuation
The asset is valued based on the cost required to recreate or replace it. This is the replacement cost approach. Useful for asset-heavy industries (real estate, manufacturing, infrastructure) but rarely used for companies as a whole because it ignores earnings power and intangible value.
2. Cash Flow-Based Valuation (Intrinsic Valuation)
The asset is valued based on the present value of future cash flows it is expected to generate. This is the Discounted Cash Flow (DCF) approach. It is the most theoretically rigorous method and forms the basis of investment analysis.
3. Selling Price-Based Valuation (Relative Valuation)
The asset is valued by comparing it to prices of similar assets that have recently been sold or are currently traded in the market. This is the multiples approach — using PE, EV/EBITDA, P/B, etc.
Discounted Cash Flow (DCF) Models
DCF valuation requires estimating future cash flows and discounting them back to present value using an appropriate discount rate. There are three primary DCF models in the NISM syllabus:
1. Dividend Discount Model (DDM)
Under DDM, the value of a stock equals the present value of all expected future dividends, discounted at the cost of equity.
Basic Formula: Value = D1 / (Ke − g)
Where:
- D1 = Dividend expected at the end of Year 1
- Ke = Cost of Equity (required rate of return)
- g = Expected constant growth rate of dividends
DDM works best for mature, dividend-paying companies with stable and predictable dividend growth.
2. Gordon Growth Model (Perpetual Growth Model)
The Gordon Growth Model is a version of DDM for companies where dividends are expected to grow perpetually at a constant rate.
Formula: Value = D0 × (1 + g) / (Ke − g) = D1 / (Ke − g)
Where:
- D0 = Current year's dividend (just paid)
- D1 = Next year's expected dividend = D0 × (1 + g)
- Ke = Cost of equity
- g = Perpetual dividend growth rate
Exam Tip: If the dividend has "just been paid," use D1 = D0 × (1+g) in the numerator. If the next dividend is "about to be paid," use it directly as D1.
3. Free Cash Flow to Equity (FCFE) Model
FCFE provides an alternative to dividends. Instead of using actual dividends paid, this model values equity by discounting the free cash flow available to equity shareholders. This is more appropriate when a company does not pay dividends or when dividends are not representative of the company's earning capacity.
FCFE = Operating Cash Flow − Capital Expenditure − Debt Repayment + New Debt Raised
The equity value equals the present value of all future FCFE, discounted at the cost of equity.
Free Cash Flow to Firm (FCFF) Model
FCFF values the entire firm (both equity and debt holders' perspective) by discounting free cash flows available to all capital providers at the Weighted Average Cost of Capital (WACC).
FCFF = Operating Cash Flow − Capital Expenditure − Tax benefit on interest
The Enterprise Value (EV) = PV of all future FCFF discounted at WACC. Equity Value = EV − Net Debt (Total Debt − Cash).
Weighted Average Cost of Capital (WACC)
WACC is the blended cost of a company's capital from all sources (equity and debt), weighted by their proportions in the capital structure.
WACC = (Proportion of Equity × Cost of Equity) + (Proportion of Debt × Cost of Debt × (1 − Tax Rate))
WACC is used as the discount rate in FCFF-based DCF valuation. A lower WACC (from cheaper financing) increases the DCF-derived equity value.
Capital Asset Pricing Model (CAPM)
CAPM establishes the relationship between risk and expected return and is used to calculate the cost of equity.
Formula: Ke = Rf + β × (Rm − Rf)
Where:
- Ke = Cost of equity (required rate of return)
- Rf = Risk-free rate (typically yield on government bonds)
- β (Beta) = Systematic risk of the stock relative to the market
- Rm = Expected return on the market (benchmark index)
- Rm − Rf = Market risk premium (excess return above risk-free rate)
Understanding Beta
- Beta = 1: The stock moves in line with the market
- Beta < 1: The stock is less volatile than the market (defensive stock)
- Beta > 1: The stock is more volatile than the market (aggressive stock)
- Beta = 0: No correlation with market movements (e.g., cash)
Relative Valuation Multiples
Relative valuation compares a company's valuation to similar companies or its own historical valuation, using standardised ratios called multiples.
Earnings-Based Valuation Multiples
| Multiple | Formula | When Used |
|---|---|---|
| Price to Earnings (PE) | Market Price / EPS | General equity valuation; widely used |
| PEG Ratio | PE Ratio / EPS Growth Rate (%) | Adjusts PE for growth; lower = more attractive |
| Price to Dividend | Market Price / Dividend per Share | Dividend-paying companies |
| EV / EBITDA | Enterprise Value / EBITDA | Cross-company comparison; removes capital structure effects |
| EV / Sales | Enterprise Value / Revenue | Loss-making companies or early-stage businesses |
Asset-Based Valuation Multiples
| Multiple | Formula | When Used |
|---|---|---|
| Price to Book Value (P/B) | Market Price / Book Value per Share | Banking, financial services, asset-heavy businesses |
| EV / Capital Employed | Enterprise Value / Capital Employed | Capital-intensive industries |
| Net Asset Value (NAV) | Total Assets − Total Liabilities (per unit) | Mutual funds, REITs, holding companies |
| Price / Embedded Value | Market Cap / Embedded Value | Insurance companies |
| EV / Capacity | Enterprise Value / Production Capacity | Commodities, cement, steel |
Key Insight — PEG Ratio
The PE ratio alone can be misleading — a high PE company may be justified if it has higher growth. The PEG Ratio adjusts for growth:
PEG Ratio = PE Ratio / Expected EPS Growth Rate (%)
- PEG < 1 = potentially undervalued relative to growth
- PEG = 1 = fairly valued relative to growth
- PEG > 1 = potentially overvalued relative to growth
Company B is cheaper than Company A if Company B has a lower PEG, even if Company B has a higher PE — because its higher growth justifies the higher PE.
Sum-of-Parts Valuation (SOTP)
Many large conglomerates operate multiple different businesses under one listed entity — for example, a company that has businesses in FMCG, hotels, and agri-commodities simultaneously.
In such cases, applying a single valuation multiple to the entire company would be misleading because different businesses deserve different multiples (based on growth rates, risk, and comparable peers).
Sum-of-Parts (SOTP) methodology:
- Value each business segment separately, using the most appropriate methodology
- Add up the valuations of all segments
- Deduct holding company discount (if applicable) and net debt
- Divide by total number of shares to get target price per share
SOTP is commonly used for conglomerates, diversified financial services companies, and companies with significant investment holdings.
Enterprise Value — The Building Block
Enterprise Value (EV) = Market Capitalisation + Total Debt − Cash and Cash Equivalents
EV represents the total value of the firm from the perspective of all capital providers. It is used as the numerator in EV-based multiples (EV/EBITDA, EV/Sales, EV/Capacity).
Equity Value = EV − Net Debt (where Net Debt = Total Debt − Cash)
Concept of Margin of Safety
Margin of Safety was popularised by Benjamin Graham and further advocated by Warren Buffett. It refers to the gap between an investment's intrinsic value and its market price.
When you buy a stock at a significant discount to its intrinsic value, the margin of safety protects you from errors in your estimates. If your valuation is wrong by 20%, but you bought at a 40% discount to intrinsic value, you still make money.
There is no universal standard for how wide the margin of safety should be — each investor defines their own threshold based on risk tolerance and confidence in the estimates.
Quick Revision — Valuation Formulas
| Model / Concept | Key Formula |
|---|---|
| Gordon Growth Model | Value = D1 / (Ke − g) |
| CAPM | Ke = Rf + β × (Rm − Rf) |
| WACC | (E/V × Ke) + (D/V × Kd × (1 − T)) |
| Enterprise Value | Market Cap + Debt − Cash |
| Equity Value from EV | EV − Net Debt |
| PE Ratio | Market Price / EPS |
| PEG Ratio | PE / EPS Growth Rate (%) |
| EV/EBITDA | Enterprise Value / EBITDA |
| P/B Ratio | Market Price / Book Value per Share |
| FCFF | Operating Cash Flow − Capex − Tax benefit on interest |
Quick Revision Points
- Price = current market price (known); Value = estimated intrinsic worth (from analysis)
- Three valuation approaches: Cost-based, Cash flow-based (DCF), Market-based (multiples)
- Gordon Growth Model: Value = D1 / (Ke − g); use D1 = D0 × (1+g) when current dividend just paid
- CAPM: Ke = Rf + β × (Rm − Rf)
- Beta < 1 = less volatile; Beta > 1 = more volatile than market
- WACC = weighted average of cost of equity and after-tax cost of debt
- EV = Market Cap + Net Debt (Debt − Cash)
- EV/EBITDA removes capital structure effects; good for comparing companies with different debt levels
- PEG Ratio < 1 = potentially undervalued; higher growth justifies higher PE
- SOTP valuation is best for conglomerates with multiple diverse business segments
- Margin of safety = intrinsic value minus purchase price; protects against estimation errors
Next in the Series
Part 11 of our NISM Research Analyst Short Notes covers Fundamentals of Risk and Return — including types of investment risk, beta, Sharpe ratio, Treynor ratio, Jensen's Alpha, behavioural biases, and measuring equity liquidity.
Access free NISM Research Analyst mock questions with detailed explanations at Research Analyst Free Mock Test.