CHAPTER 11: VALUATION (PART 2) — ASSET-BASED & DISCOUNTED CASH FLOW (DCF) METHODOLOGY

11.5 ASSET-BASED VALUATION

Under the asset-based valuation approach, the value of a company’s equity share is determined directly from the net asset value of the business, completely ignoring future earnings or cash-generation potential. The total net asset value of the company is divided by the number of outstanding equity shares to derive the value per share.

This method focuses solely on the market value of the assets less liabilities as of the valuation date. Asset-based valuation is conventionally carried out using three distinct frameworks:

The Three Frameworks of Asset-Based Valuation

1. Book Value Method

This framework utilizes the historical carrying values of assets and liabilities as recorded in the balance sheet. It is widely considered the "floor price" or the minimum value attributable to a going concern business that is expected to continue its operations in the future.

2. Replacement Value Method

This framework estimates the current market cost of replicating or replacing the entire business on an "as-is-where-is" basis. It factors in current asset market costs, adjustment of liabilities, and the transaction, legal, and operational expenses required to establish the business as a going concern in its current state. This methodology is highly appropriate for businesses operating in industries with massive entry barriers or substantial startup setup costs.

3. Break-up Value (Liquidation Value) Method

This framework estimates the salvage value of the business if operations were shut down and liquidated on the valuation date. It measures what the physical and intangible assets would fetch if sold individually in the market, less the actual settlement value of all outstanding debt and liabilities. The break-up value method is primarily reserved for distressed companies or those lacking a viable future business case.

Key Formulas (Simple Line Format)

• Book Value per Share:
  Book Value per Share = Equity Shareholders' Funds as per Balance Sheet / No. of Equity Shares Issued and Paid up

• Break-up Value per Share:
  Break-up Value per Share = (Liquidation Value of Assets - Settlement Value of Debt) / No. of Equity Shares Issued and Paid up

Step-by-Step Practical Illustration (Illustration 11.4)

Based on the financial data of Alpha Ltd, which has 10,000 outstanding equity shares, a revaluation of its assets and liabilities under different business scenarios yields the following core valuation results:

Note: Asset-based valuation is generally not considered an independent method for going concerns. In professional practice, it is used in conjunction with other methods, particularly for asset-heavy entities (such as banks or financial institutions) and distressed companies.

11.6 DISCOUNTED CASH FLOW (DCF) VALUATION

The Discounted Cash Flow (DCF) methodology has the strongest theoretical underpinnings in corporate finance. It calculates the intrinsic value of a business by estimating its future free cash flows (FCF) and discounting them back to their present value using the company's Weighted Average Cost of Capital (WACC).

The Core Step-by-Step DCF Process

Step 1: Free Cash Flow (FCF) Estimation

To perform a DCF, analysts must forecast the future operating cash flows (OCF) by projecting a detailed profit and loss (P&L) statement over a discrete period (typically 3 to 5 years). Reinvestment requirements (such as ongoing capital expenditure to maintain fixed assets and changes in working capital) are subtracted to arrive at the Free Cash Flow.

Step 2: Determination of Terminal Value (TV)

Since businesses are assumed to operate indefinitely, cash flows beyond the discrete projection period are captured in perpetuity as the Terminal Value. This is calculated by taking the projected cash flow of the year following the discrete period (Year T+1) and capitalizing it.

Step 3: Calculation of Cost of Capital (WACC)

The discount rate must reflect the risk profile of the business. The Weighted Average Cost of Capital (WACC) is calculated by multiplying the individual post-tax cost of debt and the cost of equity by their respective weights in the company's capital structure.

• Cost of Equity (CAPM): Computed using the Capital Asset Pricing Model (CAPM). For unlisted alternative assets, the cost of equity is adjusted upward by adding an illiquidity premium and specific company risk premiums.
• Cost of Debt: Calculated using the average carrying cost or the marginal borrowing rate net of tax benefits.

Step 4: Arriving at Enterprise Value and Equity Value

The sum of the present value of the projected discrete FCFs and the present value of the Terminal Value equals the Enterprise Value (EV). To isolate the Equity Value, outstanding net debt is deducted from the Enterprise Value. Dividing the Equity Value by the total outstanding equity shares yields the intrinsic value per share.

Key DCF Formulas (Simple Line Format)

• Operating Cash Flow (OCF):
  OCF = PAT + Depreciation +/- Non-cash charges in P&L +/- Changes in Working Capital

• Free Cash Flow (FCF):
  FCF = OCF - Normal Capital Expenditure (Reinvestment Requirement) - Debt Repayments (if any)

• Capital Asset Pricing Model (CAPM) Cost of Equity:
  Cost of Equity (Ke) = Rf + (Equity Beta * (ER - Rf))
  Where:

  • Rf = Risk-free rate of return (e.g., government securities rate)
  • ER = Average return expected from the equity market
  • (ER - Rf) = Market risk premium
  • Equity Beta = Volatility of company returns relative to the market

• Weighted Average Cost of Capital (WACC):
  WACC = (Weighted Cost of Equity) + (Weighted Post-Tax Cost of Debt)

• Terminal Value of FCF (Gordon Growth Model):
  Terminal Value (TV) = FCFT+1 / (WACC - g)
  Where:

  • FCFT+1 = Free Cash Flow projected for the year immediately following the discrete period
  • g = Expected terminal growth rate of profits in perpetuity

• Enterprise Value (EV):
  Enterprise Value = PV of Discrete FCFs + PV of Terminal Value

• Equity Value of the Business:
  Equity Value = Enterprise Value - Outstanding Debt

IMPORTANT TERMS FOR EXAM PREPARATION

• Tangible Net Worth: The total book value of a business excluding intangible assets (like goodwill or trademarks) and revaluation reserves, which represents pure capital.
• Going Concern: The operational assumption that a business will continue to exist, generate revenue, and meet its obligations in the foreseeable future without the threat of liquidation.
• Terminal Value (TV): The capitalized value of all free cash flows of a firm beyond the discrete forecasting horizon, representing its continuing value.
• Capital Asset Pricing Model (CAPM): A framework that establishes the required rate of return on equity by combining the risk-free rate with a risk premium scaled by the asset's beta.
• Illiquidity Premium: An additional return percentage added to the cost of equity of unlisted companies to compensate alternative investors for the inability to easily buy or sell their shares.

KEY TAKEAWAYS FOR DISTRIBUTORS

1. Asset-Based Methods Set Valuation Boundaries: While Book Value serves as the going-concern "floor price" for standard companies, the Break-up Value defines the terminal salvage value of distressed assets.
2. Unlisted Cost of Equity is Always Higher: Because alternative unlisted investments are highly illiquid, their cost of equity is adjusted upward via an illiquidity premium when performing DCF, leading to higher discount rates than listed peers.
3. WACC is the Discounting anchor: Every robust DCF model relies heavily on WACC to discount future cash flows back to the present. Any slight change in the terminal growth rate or the WACC radically swings the final equity share valuation.