Modules for Investors
Advanced Fundamental Analysis  Valuation
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The Valuation Playing Field
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In the previous chapter, we saw how you can determine the value of a company using the DCF model. Similarly, you can also use any of the other valuation methods, like the Dividend Discount Model or the comparative approach, to arrive at the value available to the shareholders. Once that’s done, what’s the next logical step? Well, isn’t it all done to arrive at a valuation number – one that helps you identify if the shares of a company are overvalued or undervalued?
Picking up the case of Eicher Motors from the previous chapter, let’s attempt to complete the valuation exercise.
Arriving at a valuation number
You’ll recall that using the DCF method, we computed the present value of Eicher Motors to be Rs. 87,846.29 crores. We can use this number to identify the intrinsic value of the company’s shares. Here’s the formula that we’ll use.
Intrinsic value of each share = Total present value of the company ÷ Total number of shares outstanding 
This screenshot from the annual report of Eicher Motors shows you the total number of shares outstanding as at the end of the year 201920.
Substituting these values in the formula, this is what we have.
Intrinsic value of each share
= Rs. 87,846.29 crores ÷ 2.7304570 crores
= Rs. 32,172.74
This is the valuation number that we get from the DCF model.
Setting your estimates
Okay, so you’ve found out that according to the DCF model, the intrinsic value of the shares of Eicher Motors is Rs. 32,172.74 each. Does this mean that each share is worth absolutes this much? Not quite true. That’s because this valuation number is not precise or exact. It is, at best, an estimate. That’s because the DCF model relies on a number of assumptions. And if we were to change any of those assumptions even slightly, the end result could vary a great deal.
Let’s try that out. Remember these estimates from the previous chapter?
 Growth rate for the forecast period: 10%
 Terminal growth rate: 3%
 Discount rate: 5%
Now, what if we changed the growth rate by just 2% and brought it up to 12%? Let’s see how that impacts the intrinsic value.
1. Calculating the free cash flows to the company at 12%
Year 
Growth rate 
Free cash flow (in rupees crores) 
Comments 
Base year (201920) 

1,241.68 
As computed earlier 
Year 1 (202021) 
10% 
1,390.68 
= 1,241.68 x (1 + 12%) 
Year 2 (202122) 
10% 
1,557.56 
= 1,390.68 x (1 + 12%) 
Year 3 (202223) 
10% 
1,744.47 
= 1,557.56 x (1 + 12%) 
Year 4 (202324) 
10% 
1,953.81 
= 1,744.47 x (1 + 12%) 
Year 5 (202425) 
10% 
2,188.26 
= 1,953.81 x (1 + 12%) 
2. Terminal value
The terminal value remains unaffected, since we’ve only modified our assumptions for the growth rate for free cash flows. The discount rate and the terminal growth rate remain the same.
So, the terminal value remains Rs. 1,02,986.50 crores.
3. Discounting the future cash flows and the terminal value to arrive at the present value of the company
The discount rate remains unchanged. But the projected free cash flows have changed, so we’ll need to compute the present value once more, for the new assumption.
Year 
Amount of FCF or terminal value (in rupees crores) 
Discount rate 
Present value of the cash flow 
Comments 
Year 1 (202021) 
1,390.68 
5% 
1,324.46 
= 1,390.68 ÷ (1 + 5%)1 
Year 2 (202122) 
1,557.56 
5% 
1,412.75 
= 1,557.56 ÷ (1 + 5%)2 
Year 3 (202223) 
1,744.47 
5% 
1,506.94 
= 1,744.47 ÷ (1 + 5%)3 
Year 4 (202324) 
1,953.81 
5% 
1,607.40 
= 1,953.81 ÷ (1 + 5%)4 
Year 5 (202425) 
2,188.26 
5% 
1,566.85 
= 2,188.26 ÷ (1 + 5%)5 

1,02,986.50 
5% 
80,692.62 
= 1,02,986.50 ÷ (1 + 5%)5 

Sum of all present values 

88,258.73 

4. Calculating the intrinsic value of each share
Using the new present value and substituting it in the formula, here’s the intrinsic value we get.
Intrinsic value of each share
= Rs. 88,258.73 crores ÷ 2.7304570 crores
= Rs. 32,323.79
See how the intrinsic value changes from Rs. 32,172.74 per share to Rs. 32,323.79 per share? Now, this may seem like a miniscule change. But if you were to simultaneously change all the estimates, the change in the intrinsic value becomes more pronounced. This is why it becomes important to set estimates and account for error margins.
The intrinsic value range
Now that you know how sensitive the intrinsic value is to even the most minor variations in the assumptions, you’ll agree that it makes more sense to use a range rather than an absolute value to identify the intrinsic value of a company. Ideally, the range that you can take is a 10% margin on either side. You can also take it higher or restrict it to 5%.
In the case of Eicher Motors, we’ll assume a margin of 10%. Given the intrinsic value we computed  Rs. 32,172.74 per share  these are the upper and lower ranges.
Upper range:
= Rs. 32,172.74 (1 + 10%)
= Rs. 35,390 per share
Lower range:
= Rs. 32,172.74 (1  10%)
= Rs. 28,955 per share
This tells us that the intrinsic value of the shares of Eicher Motors should ideally be in the range of Rs. 28,955 per share to Rs. 35,390 per share.
What does this range tell you?
The intrinsic value range as per our computation is Rs. 28,955 per share to Rs. 35,390 per share. Comparing that with the current market price of Eicher Motors, which is around Rs. 20,000 at the time of writing this, you see that the market value is below the lower range of our intrinsic value calculations.
This implies that the stock is undervalued.
Conclusions based on the value comparison
 If the current market price falls below the lower range of the intrinsic value, the stock is said to be undervalued. As a rule of thumb, investors tend to buy undervalued shares because eventually, price corrections will take the market value up to the level of the intrinsic value.
 If the current market price is within the range of the intrinsic value, the stock is said to be fairly valued in the market. Since fluctuations could take this situation either way, it’s generally not advisable to buy a stock at this stage. Investors often tend to either hold stocks that are fairly valued or occasionally, sell them to earn returns.
 If the current market price is above the upper range of the intrinsic value, the stock is said to be overvalued. As a rule of thumb, investors tend not to buy overvalued shares because eventually, price corrections will bring the market value down to the level of the intrinsic value. It’s a more common practice for investors to sell their holding and earn returns when a stock is overvalued.
The need for error margins
In the specific case of the DCF model, we saw that there are many assumptions at play, making it necessary to use error margins. But what about the valuation numbers you get using other methods? Well, those models also rely on certain assumptions of their own. This is why it’s always advisable to look at the intrinsic value as a band or a range rather than as a single, absolute value.
Here’s a quick preview of some assumptions made in valuation, across different methods.
The assumption of going concern:
Most valuation models (except perhaps the liquidation version of the assetbased approach) assume that the company being valued is a going concern. Take the DCF method, where the cash flows are forecasted assuming that the business will continue to exist for the foreseeable future. Or take DDM valuation, where dividends are projected based on this assumption. Even marketbased valuation does not specifically consider the possibility of liquidation.
The assumptions regarding growth rates and cash flows
Valuation models that rely on cash flows or dividends assume that these metrics will grow at a specific rate. Now, even in the cases where these assumptions are extremely conservative, it doesn’t nullify the fact that they are, well, assumptions. As a result, the possibility of these assumptions being invalidated do exist.
For instance, the Dividend Discount Model may assume a certain growth rate for dividend payouts for the next 5 years. But perhaps, 3 years later, a setback may prevent the company from paying dividends at all.
The assumptions regarding the industry:
Industryoriented assumptions are also an intrinsic part of any valuation process. Some methods make use of these postulations more than others. The marketbased valuation approach, where the value of a company is determined using the value of a similar company that has recently been sold off, relies greatly on industryrelated presumptions. Other valuation models too factor in these elements.
The assumptions regarding the macroeconomic scenario:
Beyond the industry, there are many macroeconomic factors that play a key role in determining the metrics used for valuation. The GDP growth rate, the riskfree rate and even the general outlook for a country’s economy impact the process.
Risks associated with assumptions
The assumptions explained above all have their own set of risks. The risks also depend on the kind of company you’re valuing. For instance, if you’re valuing a startup, you may not have a lot of historical data to rely on. This calls for a heavy set of assumptions, which may almost certainly be invalidated in the future.
Alternatively, if you’re evaluating an ecommerce company, there’s a huge risk that the entry of a major international competitor with deep pockets and infinite resources could throw the projected course of business way off. Similarly, if your company operates in an industry that enjoys special tax benefits, there’s always the risk of those benefits being modified or withdrawn by the government.
Wrapping up
This concludes the discussion on the valuation playing field. Clearly, it's not a very even ground, but accounting for potential errors can help you make up for the risks associated with your assumptions, to a certain extent. Beyond this, valuation also helps analysts and investors arrive at many key ratios and numbers. This is what we’ll look at in the next chapter of Smart Money.
A quick recap
 Intrinsic value of each share = Total present value of the company ÷ Total number of shares outstanding
 The valuation number is not precise or exact. It is, at best, an estimate. And if we were to change any of those assumptions even slightly, the end result could vary a great deal.
 It makes more sense to use a range rather than an absolute value to identify the intrinsic value of a company.
 If the current market price falls below the lower range of the intrinsic value, the stock is said to be undervalued.
 If the current market price is within the range of the intrinsic value, the stock is said to be fairly valued in the market.
 If the current market price is above the upper range of the intrinsic value, the stock is said to be overvalued.
 There are many assumptions used to build valuation models.
 These assumptions include the assumption of going concern and the assumptions regarding cash flows, the macroeconomic conditions and the industry.
 These assumptions all have their own set of risks. The risks also depend on the kind of company you’re valuing.
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