Comprehensive Study Notes: NISM Series XV Research Analyst - Chapter X: Valuation Principles (Part 1)

Understanding the Core Concepts of Valuation

Valuation is the analytical process of determining the current or projected worth of an asset or a firm. In investment research, understanding the fundamentals of valuation is crucial for making informed recommendations.

The Fundamental Difference Between Price and Value

In financial markets, price and value are often used interchangeably, but they represent entirely different economic concepts:

• Price: This is the market-determined exchange rate of a security at any given point in time. It is highly visible, readily available from the stock market, and known to all market participants.
• Value: This represents the actual economic or intrinsic worth of the security. Unlike price, value is not universally agreed upon or directly visible; it is based on the detailed evaluation, fundamental analysis, and professional judgment of the valuer at a specific point in time.

Key Takeaway: Price is what you pay; value is what you get. A stock's price might fluctuate wildly based on market sentiment, but its intrinsic value is driven by underlying business returns and long-term earnings potential in fundamental analysis.

Core Approaches to Valuation

Valuation techniques are broadly classified into three primary approaches depending on the methodology used to determine worth.

1. Cost-Based Valuation

Under this approach, the value of an asset is directly linked to the historical or current cost of replication or creation.

• Definition: An asset is valued based on the cost that needs to be incurred to create or replace it.
• Application: This is typically useful when assessing physical assets where the cost changes according to the market value of replacing the asset.

2. Cash Flow-Based Valuation (Intrinsic Valuation)

The intrinsic valuation approach views an asset as a generator of future economic benefits.

• Definition: This approach assigns a value to an asset based on what an investor would be willing to pay today for the future cash flows expected to be generated by that asset over its life.
• Application: It is widely considered the most theoretically sound method for valuing operating businesses, as it reflects the business's long-term earning power.

3. Selling Price-Based Approach (Relative Valuation)

Relative valuation is highly intuitive and mirrors how decisions are made in everyday life, such as comparing technical specifications and prices of similar phone brands before purchasing.

• Definition: Under this approach, an asset is valued based on the market prices of other similar or comparable assets.
• Application: It relies on market multiples to compare a target company against its industry peers to determine if it is relatively cheap or expensive.

Discounted Cash Flows (DCF) Model for Business Valuation

The Discounted Cash Flows (DCF) model is the cornerstone of intrinsic valuation. It operates on the principle that the value of a business is the sum of its expected future cash flows, discounted back to the present day using an appropriate cost of capital.

The study notes highlight three distinct approaches to DCF models:

1. Dividend Discount Model (DDM)

The DDM is based on the premise that the primary cash flows an equity investor directly receives from a company are its dividends.

• Methodology: Under this model, the expected future dividend payments of a company are projected and then discounted back to their present value using the cost of capital.
• Formula Representation (Simple Line Format): Value of Stock = Sum of (Expected Future Dividend in Year t / (1 + Cost of Capital) raised to the power of t)

2. Gordon Growth Model (Perpetual Growth Model)

The Gordon Growth Model is a specialized, simplified version of the Dividend Discount Model.

• Methodology: It provides a way to value a dividend-paying company where the dividend is expected to grow perpetually at a constant rate.
• Formula Representation (Simple Line Format): Value of Stock = Next Year Expected Dividend / (Cost of Capital - Perpetual Dividend Growth Rate)

3. Free Cash Flow to Equity Model (FCFE)

For many companies, actual dividend payments do not reflect their true capacity to distribute cash. The FCFE model solves this by focusing on cash flow instead of actual dividends.

• Methodology: Under this model, equity is valued by discounting the projected free cash flows to equity shareholders instead of the actual dividends paid by the company.
• Formula Representation (Simple Line Format): Value of Equity = Sum of (Free Cash Flow to Equity in Year t / (1 + Cost of Equity) raised to the power of t)

The Capital Asset Pricing Model (CAPM)

To discount future cash flows under the DCF model, analysts must determine the appropriate discount rate (cost of equity). The Capital Asset Pricing Model (CAPM) is the industry-standard framework used for this purpose.

Understanding CAPM and the Cost of Equity

CAPM establishes the explicit relationship between the risk of a security and its expected return, forming the basis for the cost of equity.

The model is built upon three essential components:

1. Risk-Free Rate of Return (Rf): The theoretical return on an investment with zero risk, typically represented by sovereign debt instruments.
2. Expected Market Return (Rm): The return expected on a broad stock market portfolio.
3. Beta of the Stock (Beta): A return premium that compensates for the business and financial risks specific to the stock of the company itself. It measures the volatility in the stock price relative to changes in the benchmark index or stock market.

Systematic Risk and Beta Interpretations

Beta measures the risk of an investment that cannot be diversified away.

• Beta = 1.0: The security's price will move exactly with the market.
• Beta < 1.0: The security will be less volatile than the market.
• Beta > 1.0: The security will be more volatile than the market.

CAPM Cost of Equity Formula

The CAPM formula calculates the cost of equity by adding a risk premium (adjusted by Beta) to the risk-free rate.

• Formula Representation (Simple Line Format): Cost of Equity = Risk Free Rate (Rf) + Beta * Market Risk Premium Where: Market Risk Premium = Expected Market Return (Rm) - Risk Free Rate (Rf)

Key Terms and Exam-Relevant Definitions

• Intrinsic Value: Refers to the value of a company stock determined through fundamental analysis, completely independent of its current market price.
• Beta: A measure of systematic risk that compares the volatility of an investment relative to the broader market index.
• Cost of Capital: The minimum rate of return required by investors to fund a business, used as the discount rate in DCF models.
• Free Cash Flow to Equity (FCFE): The net cash flow available for equity shareholders after all operating expenses, reinvestments, and debt payments are settled.