INVESTMENT BANKING

An investment bank performs two basic, critical functions:

1) acting as an intermediary for capital raising, and
2) as an advisor on M&A transactions and other major corporate actions.
As an intermediary, it connects companies that need capital with investors who have capital to spend.
It facilitates this through debt and equity offerings. As an advisor, an investment bank counsels
companies on such corporate actions as mergers, acquisitions, spinoffs, and restructurings. Here are
examples of some of the different functions a banker will perform, as well as some other important
basics to know about the job:
• Underwriting: an arrangement whereby investment bankers raise investment capital from
investors on behalf of corporations and governments who issue public securities (“public
offering”). These securities can come in the form of equity (IPO, secondary equity issuance)
or debt (high-grade debt, high yield bonds, government securities, etc). Investment banks
make money by securing underwriting fees (% of the capital raised) from the public offerings.
• Financial Restructuring: provide advisory services including recommending the sale of
assets (corporate divestitures), potential bolt-on acquisitions and merger opportunities, or
even working with M&A bankers to sell the company entirely.
• Investment Banking Job Hierarchy: Analysts → Associates → Vice Presidents (VPs) →
Directors→ Managing Directors (MDs)
• General Pitch Book: Created by the bankers and used to guide introductions and
presentations during a sales pitch. Pitch Books contain general information and include a wide
variety of selling points, such as an overview of the investment bank, including details of its
specific capabilities in research, corporate finance, and sales & trading, and usually provides
updates on industry/market and recommendations on the optimal capital structure strategy for
the company.
• Deal-Specific Pitch Book: Highly customized depending on the situation; includes
valuations, comparable company analysis, and industry analyses, as well as the bank’s
reputation, prominence and acumen of its research analysts, performance on past/similar
work, and information on rankings/expertise.
Buy side vs Sell side in Investment Banking: -
Buy-Side vs Sell Side -The Buy Side refers to firms that purchase securities and includes
investment managers, pension funds, and hedge funds. The Sell-Side refers to firms that issue, sell,
or trade securities, and includes investment banks, advisory firms, and corporations.

Buy-Side – is the side of the financial market that buys and invests large portions of securities for
the purpose of money or fund management.
The Role of the Buy Side:
• Manage their clients’ money
• Make investment decisions (buy, hold, or sell)
• Earn the best risk-adjusted return on capital
• Perform in-house research on investment opportunities
• Perform financial modeling and valuation
• Find investors and recruit capital to manage
• Grow assets under management (AUM)

Sell-Side – is the other side of the financial market, which deals with the creation, promotion, and
selling of traded securities to the public.
The Role of the Sell Side:
• Advise corporate clients on major transactions
• Facilitate raising capital, including debt and equity
• Advise on mergers and acquisitions (M&A)
• Win new business (build relationships with corporates)
• Market and sell securities
• Create liquidity for listed securities
• Help clients get in and out of positions
• Provide equity research coverage of listed companies
• Perform financial modelling and valuation

Valuation: -
Every asset, financial as well as real, has a value. There are different methods used to value each asset
and it is essential that you identify sources of value to successfully manage and invest in those assets.
Broadly, there are two approaches to valuation:
1) Absolute Valuation:
It relates the value of an asset to its capacity to generate cash flows and the risk in these cash
flows. Generally, Discounted Cash Flow (DCF) or Dividend Discount model (DDM) valuation is
used here. It is the present value of expected future cash flows on that asset.
2) Relative Valuation:
The value of asset is estimated by looking at price of comparable assets relative to a common
variable such as earnings, cash flows, book value or sales. Further, in few specific circumstances,
contingent claim valuation (using option pricing) is also used to measure the value of asset. These
are real options.

3) Asset Based Valuation:

Asset-based valuation is a method used to determine the value of a company or business by
assessing its tangible and intangible assets and liabilities. This approach is often used when a
company's market value is not reflective of its underlying assets or when the company is not
generating significant earnings or cash flows. Asset-based valuation is particularly useful for
companies with a substantial asset base, such as real estate companies, holding companies, or
distressed businesses.

The basic formula for asset-based valuation is:

Asset-Based Value = Total Assets - Total Liabilities

Further, in few specific circumstances, contingent claim valuation (using option pricing) is also used
to measure the value of asset. These are real options.

Absolute Valuation
1) Dividend Discount Model
The dividend discount model (DDM) is a quantitative method used for predicting the price
of a company's stock based on the theory that its present-day price is worth the sum of all
of its future dividend payments when discounted back to their present value. It attempts to
calculate the fair value of a stock irrespective of the prevailing market conditions and
considers the dividend payout factors and the market-expected returns. If the value obtained
from the DDM is higher than the current trading price of shares, then the stock is
undervalued and qualifies for a buy, and vice versa.

Advantages –
• It is the most commonly used model to calculate share price and is the easiest to
understand.
• It values a company's stock without considering the market conditions, so it is easier
to compare companies of different sizes and industries.

Disadvantages –
• It does not consider non-dividend factors such as brand loyalty, customer retention
and the ownership of intangible assets, all of which increase the value of a company.
• The Gordon Growth Model also relies heavily on the assumption that a company's
dividend growth rate is stable and known.

Dividends are appropriate as a measure of cash flow in the following cases:

• The company has a history of dividend payments.
• The dividend policy is clear and related to the firm's earnings.
 • The perspective is that of a minority shareholder.

Firms in the mature stage of the industry life cycle are most likely to meet the first two
criteria.

Types of DDM

Single Stage Model (Gordon Growth Model)

The Single-Stage Dividend Discount Model (SDDM), also known as the Gordon Growth Model, is
a simplified valuation model used in finance to estimate the intrinsic value of a stock based on the
assumption that dividends will grow at a constant rate indefinitely. It is a straightforward and widely
used approach for valuing stocks when it is reasonable to assume that a company will maintain a
stable and consistent growth rate in its dividend payments into the future.
The formula for the Single-Stage Dividend Discount Model is as follows:
P = D1 / (r - g)
Where:
P = Intrinsic stock price
D1 = Expected dividend per share one year from now
r = Required rate of return (cost of equity)
g = Constant growth rate of dividends

Example:
As a hypothetical example, consider a company whose stock is trading at $110 per share. This
company requires an 8% minimum rate of return (r) and will pay a $3 dividend per share next year
(D1), which is expected to increase by 5% annually (g).

 The intrinsic value (P) of the stock is calculated as follows:

According to the Gordon growth model, the shares are currently $10 overvalued in the market.

Assumptions of Gordon Growth Model

1) The Gordon growth model values a company's stock using an assumption of constant growth
in dividend payments that a company makes to its common equity shareholders.
2) The GGM assumes that a company exists forever and pays dividends per share that increase
at a constant rate.
3) To estimate the intrinsic value of a stock, the model takes the infinite series of dividends per
share and discounts them back to the present using the required rate of return.
Advantages
1) The GGM is commonly used to establish intrinsic value and is considered the easiest formula
to understand.
2) The model establishes the value of a company's stock without accounting for market
conditions, which simplifies the calculation.
3) This straightforward approach also provides a way to compare companies of different sizes
and in different industries.

Disadvantages
1. The Gordon growth model ignores non-dividend factors (such as brand loyalty, customer
retention, and intangible assets) that can add to a company's value.
2. It assumes that a company's dividend growth rate is stable.
3. It is very sensitive to values of assumptions such as growth rate and discount rate, and
gives bad results as “g” comes closer to “r”.

Multi-Stage Model
The Multi-Stage Dividend Discount Model (MSDDM) is a valuation model used in finance to
estimate the intrinsic value of a stock when a company's dividend growth is expected to follow a non-
constant pattern, consisting of multiple stages with different growth rates. This model acknowledges
the fact that companies may experience different growth phases in their dividend payments over time.
There are three common variations of the MSDDM: the Two-Stage DDM, the Three-Stage DDM,
and the H-Model.

1) Two-Stage Dividend Discount Model:

Assumption: This model assumes that a company goes through two distinct stages of dividend
growth: an initial high-growth phase and a subsequent stable growth phase.
Formula: The intrinsic value of the stock in this model is calculated by estimating the present value
of dividends in each stage separately and then summing them up. The formula generally looks like
this:
Where:
V0 = Intrinsic stock price
D0 = Dividend in current period
r = Required rate of return (cost of equity)
gs = Growth rate of dividends during the high-growth stage
gL = Growth rate of dividends during the stable growth stage
n = number of years

2) Three-Stage Dividend Discount Model:

Assumption: This model assumes that a company goes through three distinct stages of dividend
growth: an initial high-growth phase, a transitional phase, and a stable growth phase.
Formula: Similar to the Two-Stage Model, the intrinsic value in the Three-Stage DDM is calculated
by estimating the present value of dividends in each stage and summing them up. The formula
generally looks like this:

Where, Vn = D0(1+gs)m(1+gt)n-m(1+gL)/(r-gL)

Where:
V0 = Intrinsic stock price
D0 = Dividend in current period
r = Required rate of return (cost of equity)
m = period of initial high growth phase
n = period of transition growth phase
gs = Growth rate of dividends during the high-growth stage
gt = Growth rate of dividends during the transitional phase
gL= Growth rate of dividends during the stable growth stage
3) H-Model
The H-Model, also known as the Multistage Dividend Discount Model, is a variation of the Dividend
Discount Model (DDM) used in finance to estimate the intrinsic value of a stock. It is designed to
account for companies that are expected to go through two stages of dividend growth: an initial high-
growth phase followed by a transition to a stable growth phase. The H-Model is named after its
shape, which resembles the letter "H" due to the smooth transition between growth phases.
The key assumption of the H-Model is that the company's dividends will initially grow at a higher
rate (g1) during the high-growth phase and then gradually decline linearly until they reach a stable,
constant growth rate (g2) in the second stage. The model incorporates this transition more smoothly
compared to the Two-Stage Dividend Discount Model, which assumes an abrupt change in growth
rates.

Where:
P0 = Intrinsic value of stock
D0 = Dividend in current period
r = Required rate of return (cost of equity)
g1 = Growth rate of dividends during the high-growth stage
g2 = Growth rate of dividends during the stable phase
H = (t/2) Half-life (in years) of high-growth period

Example:
A company recently issued a dividend of $3. The expected growth rate is 10%, and you expect the
rate to fall to a stable growth rate of 2% over the next twelve years. If the required rate of return is
11%, what would the value of a share in the hypothetical company be under the H-model?
  We are given all the components that are used in the H-model, so, using the formula, we get:
Stock Value = (D0(1+g2))/(r-g2) + (D0*H*(g1-g2))/(r-g2)
Stock Value = ($3(1+0.02))/(0.11–0.02) + ($3*(12/2)*(0.10-0.02))/(0.11–0.02)
Stock Value = $50.00

2) DCF Valuation
To use discounted cash flow valuation, you need
• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get present value
The value of a risky asset can be estimated by discounting the expected cash flows on the asset
over its life at a risk-adjusted discount rate.

Steps to DCF
1) Forecasting Cashflows – The cashflows are forecasted by forecasting the components that
make FCFF. They are forecasted usually for 5-10 years depending on the company and the
growth stage it is at
2) Calculate the discount rate – If FCFE is used, calculate cost of capital of the firm using the
CAPM model or any such suitable method. If FCFF is used, the cashflows need to be
discounted using WACC (Weighted average cost of capital)
3) Calculate the terminal value – If cashflows are forecasted for 5 years, the terminal value can
be calculated as on year 5 and the be discounted to year 0 along with other cashflows. The
terminal value can be calculated by dividing the last cashflow forecast by the difference
between discount rate and terminal growth rate or by using the multiple approach as discussed
above
4) By adding the sum of the discounted FCFF and terminal value, we arrive at the enterprise value.
We can subtract net debt to arrive at the equity value. In case FCFE has been forecasted, the
sum of the discounted FCFEs will be equal to the equity value.
Advantages of DCF
DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity,
weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes
closest to estimating intrinsic value of the asset/business.

Disadvantages of DCF
DCF models heavily rely on assumptions about future cash flows, growth rates, discount rates, and
terminal values. Small changes in these assumptions can lead to significant variations in the calculated
intrinsic value, making the model sensitive to inputs.

FCFF and FCFE

FCFF
• FCFF (Free Cash flow to the Firm) is the cash available for all forms of investors (debt holders
and equity holders).
• FCFF = NI + Interest(1-t) + Depreciation - Capex – Increase in Working Capital
• Note: If FCFF is used as cash flow while doing valuation of a firm, then WACC is used a
corresponding discount rate to discount back all the cash flows to present date.

FCFE
• FCFE (Free Cash flow to Equity) is the cash available to common shareholders after funding
capital requirements, working capital needs, and debt financing requirements. It is calculated.
• FCFE = NI + Depreciation - Capex – Increase in Working Capital + Net Borrowings
• Note: If FCFE is used as cash flow while doing valuation of a firm, then COE is used a
corresponding discount rate to discount back all the cash flows to present date.

FCFF vs FCFE
• The differences between FCFF and FCFE account for differences in capital structure and
consequently reflect the perspectives of different capital suppliers.
• FCFE is easier and more straightforward to use in cases where the company's capital structure
is not particularly volatile.
• On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF
is generally the best choice.

Free Cash Flows vs Dividends

Analysts often prefer to use free cash flow rather than dividend-based valuation for the following
reasons:
• Many firms pay no, or low, cash dividends.
• Dividends are paid at the discretion of the board of directors. It may, consequently, be poorly
aligned with the firm's long run profitability.
• Free cash flows may be more related to the long-run profitability of the firm as compared to
dividends.
Calculation of Discount Rates

Cost of Equity

A firm's cost of equity represents the compensation the market demands in exchange for owning the
asset and bearing the risk of ownership. There are several methods to calculate the cost of equity, and
here are some of the most commonly used ones:

1) Dividend Discount Model (DDM):

• The Dividend Discount Model calculates the cost of equity based on the expected future
dividends paid to shareholders.
• The formula is: Cost of Equity (Ke) = Dividend per Share (DPS) / Current Stock Price (P) +
Growth Rate (g)
• This method is suitable for companies that pay dividends regularly.

2) Gordon Growth Model (GGM):

• The Gordon Growth Model is a variation of the DDM that is used when dividends are
expected to grow at a constant rate indefinitely.
• The formula is: Ke = (DPS / P) + g
• It assumes that dividends will grow at a steady rate, making it appropriate for mature, stable
companies.

3) Capital Asset Pricing Model (CAPM):

• The CAPM calculates the cost of equity based on the relationship between a stock's expected
return and its systematic risk (beta).
• The formula is: Ke = Risk-Free Rate (Rf) + Beta (β) * (Market Risk Premium)
• It is widely used for companies with publicly traded stocks and access to market data.

4) Bond Yield Plus Risk Premium Approach:

• This approach starts with the yield of a company's long-term bonds and adds a risk premium
to estimate the cost of equity.
• The formula is: Ke = Yield on Company's Bonds + Risk Premium
• It is useful when a company has issued bonds that are considered representative of its risk.

5) Build-Up Method:
• The Build-Up Method calculates the cost of equity by adding various risk premiums to the
risk-free rate. These premiums include equity risk premium, size premium, and specific
company risk.
• The formula is: Ke = Risk-Free Rate + Equity Risk Premium + Size Premium + Specific
Company Risk Premium
• It is particularly useful for private companies with limited market data.
 6) Earnings Capitalization Model (ECM):
• The ECM estimates the cost of equity based on the company's expected earnings and the
capitalization rate (the required rate of return).
• The formula is: Ke = Earnings per Share (EPS) / Current Stock Price (P)
• It is suitable for valuing companies based on their earnings potential.

7) Comparable Company Analysis (CCA):

• CCA estimates the cost of equity by analyzing the market valuations of similar publicly traded
companies in the same industry.
• It involves comparing key financial metrics and applying the valuation multiples from
comparable companies to the target company.

Capital Asset Pricing Model (CAPM)

No matter how much you diversify your investments, some level of risk will always exist. So,
investors naturally seek a rate of return that compensates for that risk. The capital asset pricing model
(CAPM) helps to calculate investment risk and what return on investment an investor should expect

The model starts with the idea that individual investment contains two types of risk:

1. Systematic Risk – These are market risks—that is, general perils of investing—that cannot
be diversified away. Interest rates, recessions, and wars are examples of systematic risks.
2. Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In
more technical terms, it represents the component of a stock's return that is not correlated with
general market moves.

Modern portfolio theory shows that specific risk can be removed or at least mitigated through
diversification of a portfolio. The trouble is that diversification still does not solve the problem of
systematic risk; even a portfolio holding all the shares in the stock market can't eliminate that risk.
Therefore, when calculating a deserved return, systematic risk is what most plagues investors.

CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an individual
stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the
CAPM, which describes the relationship between risk and expected return.

Ke = Rf + β*(Rm-Rf)

Where,
Ke= Cost of Equity
Rf= Risk Free Rate of Return
Rm= Market Return
β = Beta, measure of systematic risk
Rm-Rf= Equity Risk Premium
Beta Calculation
Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market,
such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much
they deviate from the market. A stock that swings more than the market over time has a beta above
1.0. If a stock moves less than the market, the stock's beta is less than 1.0

For e.g. – A beta of 2 implies that if the market moves by 1%, the stock will move by 2% in the same
direction.

How to calculate Beta for Non-Public companies?

Identify a benchmark company and find its beta and then unlever the beta-

Lever up the beta using debt and equity estimates of your company-

How to calculate Risk Premium?

The equity risk premium is the return in excess of the risk-free rate that investors require for holding
equity securities. It is usually defined as the difference between the required return on a broad equity
market index and the risk-free rate:

1) Historical estimates – It is the difference between the historical mean return for a broad-
based equity-market index and a risk-free rate over a given time period
2) Forward looking estimates – Gordon Growth Model
GGM equity risk premium = (1-year forecasted dividend yield on market index) +
(consensus long-term earnings growth rate) - (long-term government bond yield)
3) Survey/analyst’s estimates - use the consensus of the opinions from a sample of people
use the consensus of the opinions from a sample of people.
Cost of Debt
The cost of debt is the total interest expense owed on a debt. There are a couple of different ways to
calculate a company’s cost of debt, depending on the information available:
1) Yield to Maturity Approach
2) Debt Rating Approach

Yield to Maturity Approach

This method calculates the cost of debt by considering the current market price of the debt instrument,
its face value, and the remaining time until maturity. The YTM is the rate at which the present value
of the future cash flows from the debt instrument equals its current market price. It's a more accurate
method for bonds and other fixed-income securities.

Debt Rating Approach

Companies with publicly traded bonds often have credit ratings. You can use the yield on bonds with
similar credit ratings as a proxy for the cost of debt for a specific company.

For example, assume that the average maturity of a company’s debt is 10 years, and the company
itself has a rating of BBB.

We will first observe that the yield on debt with a similar rating is 7%. Given the tax-rate of 35%, the
after-tax cost of debt for the company will be:

= 7% (1-35%) = 4.55%
WACC

Weighted average cost of capital (WACC) represents a firm's average after-tax cost of capital from
all sources, including common stock, preferred stock, bonds, and other forms of debt. WACC is the
average rate that a company expects to pay to finance its assets.

Weighting for debt and equity can be based on the following:

1) Market values
2) Book values
3) Target values

The discount rate should correspond to the type of cash flow being discounted. Cash flows to the
entire firm should be discounted with the WACC. Alternatively, cash flows in excess of what is
required for debt service should be treated as cash flows to equity and discounted at the required return
to equity.

Terminal Value
There are two basic approaches for calculating terminal value: using a single-stage model or a multiple
approach:

1) Using Single Stage Model:

Where, g is the rate at which we expect the stock to grow perpetually.

2) Multiple Approach:

The other way to do this is to use valuation multiples (like P/E ratios) to estimate terminal value.
The terminal value in year n in terms of P/E, for example, would be expressed as:

terminal value in year n = (trailing P/E) x (earnings in year n) terminal value in year n=
(leading P/E) x (forecasted earnings in year n+1)
Relative Valuation
A relative valuation model is a business valuation method that compares a company's value to that of
its competitors or industry peers to assess the firm's financial worth. Relative valuation models are an
alternative to absolute value models, which try to determine a company's intrinsic worth without any
reference to another company or industry average. The investors may use relative valuation models
when determining whether a company's stock is a good buy.

Advantages of Relative valuation

1) The allure of using multiples is the ease of use, and it is a much quicker way to value a
company. The calculation of the ratios usually consists simply of a simple arithmetic operation,
usually a division, without going into the complexity of the calculation of the cash flow
discount.
2) The intuitive nature of relative valuation is attractive to prospective investors than the
technical nature of DCF.

Disadvantages of Relative valuation

1) It is difficult to find true value for some companies, because of low trading pattern and small
market capitalization.
2) Another issue with using multiples for valuation is it builds in errors that the market might be
making in valuing any of the comparable companies. For example, if the market has
overvalued all computer software companies, then using the average or median PE ratio of
these companies will lead to us overvaluing the company.
3) There is no assurance that the "cheaper" company will outperform its peer.

Common Multiples
There are two main types of valuation multiples
1) Equity Multiples – These use prices of the company’s share. For example, P/E, P/B, etc.
2) Enterprise Value Multiples – These use EV of the company. For example, EV/EBIT, EV/
EBITDA, etc.

Equity level ratios can be affected by changes in the capital structure without any change in the
Enterprise value. Enterprise level ratios help compare companies with different leverage ratios. Also,
Enterprise level ratios are generally less affected by accounting changes/ differences as the
denominator is higher than that in the case of equity ratios.

Some of the common metrics used in this type of valuation include:

1) Price to Earnings or P/E – The price-to-earnings ratio (P/E ratio) is the ratio for valuing a
company that measures its current share price relative to its per-share earnings (EPS). P/E may
be estimated on a trailing (backward-looking) or forward (projected) basis and is the most
widely used tool by which investors and analysts determine a stock's relative valuation. It is
read with expected growth to assess how stocks are relatively valued. The lower the P/E ratio,
the more attractive the investment.
 2) Price to Book or P/B – Companies use the price-to-book ratio (P/B ratio) to compare a firm's
market capitalization to its book value. It's calculated by dividing the company's stock price
per share by its book value per share (BVPS). It is often read with ROE. A stock with lower
P/B ratio and higher ROE is valued higher.

3) Price to Sales or P/S – The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a
company's market capitalization (the number of outstanding shares multiplied by the share
price) and divide it by the company's total sales or revenue over the past 12 months. It is
assessed with net margin (Higher is better). The lower the P/S ratio, the more attractive the
investment.

4) Enterprise Value to EBITDA or EV/EBITDA – Investors and analysts use the enterprise
value (EV) metric to calculate a company's total monetary value or assessed worthwhile
EBITDA is a useful way to measure a company’s overall financial performance and
profitability. The ratio is used to compare the value of a company, debt included, to the
company’s cash earnings less non-cash expenses. It's ideal for analysts and investors looking
to compare companies within the same industry. This ratio is read along with reinvestment
rate to judge how stocks are relatively valued. A stock with lower EV/EBITDA and low
reinvestment needs is attractive.

5) EV/Sales – Enterprise value-to-sales is a financial valuation measure that compares the

enterprise value of a company to its annual sales. Generally, a lower EV/sales multiple will
indicate that a company may be more attractive or undervalued in the market.

Understanding relative valuation using PE multiple: A company with a high P/E ratio is
trading at a higher price per dollar of earnings than its peers and is considered overvalued. Likewise,
a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered
undervalued. This framework can be carried out with any multiple of price to gauge relative market
value.

Therefore, if the average P/E for an industry is 10 times and a particular company in that industry is
trading at 5 times of earnings, it is relatively undervalued to its peers.

Estimating Relative Value of Stock: In addition to providing a gauge for relative value, the
P/E ratio allows analysts to back into the price that a stock should be trading at based on its peers.

Example: If the average P/E for an industry is 20, it means the average price of stock from a company
in the industry trades at 20 times its EPS.

Company A trades for Rs. 50 in the market and has an EPS of Rs. 2. The P/E ratio is clearly 25. This
is higher than the industry average of 20, which means Company A is overvalued. If Company A
were trading at 20 times its EPS, the industry average, it would be trading at a price of Rs. 40, which
is the relative value. In other words, based on the industry average, Company A is trading at a price
that is Rs. 10 higher than it should be, representing an opportunity to sell.
Comparison of P/E ratio and EV/EBITDA

P/E ratio is widely known and used as an indicator of a company's future growth potential.
However, it does not reveal a full picture, and it is most useful when comparing only companies
within the same industry or comparing companies against the general market.

There are problems that arise for investors with the use of the P/E ratio. The stock price can get
run up if investors are overly optimistic causing an overvalued P/E ratio. Also, the earnings portion
of the metric can be manipulated somewhat.

The EV/EBITDA ratio helps to allay some of the P/E ratios downfalls and is a financial metric
that measures the return a company makes on its capital investments. EBITDA provides a clearer
picture of the financial performance of a company since it strips out debt costs, taxes, and
accounting measures like depreciation, which spreads the costs of fixed assets out for many years.
The other component, EV is the sum of a company's equity value or market capitalization plus its
debt less cash. It is typically used in buyouts. The EV/EBITDA is calculated to achieve an earnings
multiple that is more comprehensive than the P/E ratio.

However, the EV/EBITDA ratio has its drawbacks, such as the fact that it doesn't include capital
expenditures, which for some industries can be significant. As a result, it may produce a more
favourable multiple by not including those expenditures.

The P/E ratio has been established as a prime market valuation metric, and the sheer volume of current
and historical data gives the metric weight in regard to stock analysis. Some analysts contend that
using the EV/EBITDA ratio versus the P/E ratio as a valuation method produces better investment
returns.

Both metrics have inherent advantages and disadvantages. As with any financial metric, it's
important to consider several financial ratios including the P/E ratio and the EV/EBITDA
ratio in determining whether a company is fairly valued, overvalued, or undervalued.

Industry Specific Ratios

• Cement – EV/Ton
• Retail – Same store sales growth (SSSG), New Store Growth (Revenue); Per Sq. Ft.
Sales (Store productivity) say compare DMART > BigBazaar; EV/EBITDA,
EV/EBIDTAR
• Banking - P/BV, P/E
• Insurance – P/B, P/NAV, P/Embedded Value
• Power - EV/EBITDA, EV/BV FMCG- EV/EBITDA, EV/Sales
• Automobile- EV/EBITDA Telecom -ARPU
• Healthcare Hospitals – Patient bed Days (Occupancy rate, no of beds, no. of patients);
Contract/Own – Lease (different D&A); EV/Operating bed, EV/EBIDTAR, ALOS
• Pharma – EV/EBITDA, PEG (Size different, product mix similar); MRs productivity
(Operations); Labs – Same lab revenue growth + new growth
• Cab Aggregators – Passenger Ride Km, EV/No. of rides completed, EV/Gross ride value
Restaurant Aggregators – EV/Gross sales Value
 • Online /Ecommerce – GMV Real Estate – EV/NAV
• Social Media – EV/Daily Monthly Users, EV/Next 12 month sales, EV/last 12 month sales
Multiple Sector Comments
EV/ Revenue Various Early Stage Companies
EV/ Various Subscriber Based Business such as cable and DTH
Subscriber
EV/ EBITDA Various Many industrial and consumer industries, but not
bank, insurance, Oil, Gas, Retail
EV/EBITA Various Commonly used in several media industry sub-
sectors, gaming, chemicals, bus and retail
Used when EBITDA multiples are less relevant due
to significant differences in asset financing (e.g. –
mix of leases, rentals, ownership)
EV/EBITDA Oil & Gas Excludes exploration expenses
X
EV/ Retail, Airlines Used when there are significant rental and lease
EBITDAR expenses incurred by business operations
P/BV Tech/Banks/Insurance Banks shareholder equity is important because it is
looked as a buffer/protection for depositors
EV/FFO Real Estate Principally used in US
P/E Various Often using normalized cash earnings, excluding
both exceptional items & goodwill amortization
PEG Ratio High tech, high growth Big difference in growth across companies

Private Company Valuation

The process of valuing private companies is not different from the process of valuing public
companies. You estimate cash flows, attach a discount rate based upon the riskiness of the
cash flows and compute a present value.
As with public companies, you can either value
1) The entire business, by discounting cash flows to the firm at the cost of
capital.
2) The equity in the business, by discounting cashflows to equity at the cost of
equity.

When valuing private companies, you face two standard problems:

1) There is not market value for either debt or equity
2) The financial statements for private firms are likely to go back fewer years, have less detail
and have more holes in them.
Valuation Methods
1) Market Approach
Because it is difficult to establish private company valuation multiples, the most common
approach is to use comparable company analysis (CCA). This approach, the appraiser searches
for publicly- traded companies that closely resemble the subject company.

Using this approach, public companies in the same industry of a similar size, age, and growth rate
are identified, and averages of their multiples or valuations are calculated for comparison to the
subject company. This gives the appraiser an idea of where the subject private company fits within
the industry and how it compares to its competitors.
2) Income Approach
The basis of the income or present value approach is the premise that the subject company’s current
full cash value is equal to the present value of future cash flows it will provide over its remaining
economic life.

Estimating the revenue growth of the subject company by averaging the revenue growth rates of
the comparable companies and then adjusting for company specific factors is the first step. After
estimating revenue growth, expected changes in operating expenses, taxes, and working capital are
estimated. Once all of these estimates are completed, free cash flow is calculated, providing the
operating cash remaining after the deduction of expenditures. The next step is calculating the
average beta (measure of market risk, disregarding debt), tax rates, and debt-to-equity (D/E) ratios
of comparable companies, and ultimately, the weighted average cost of capital (WACC).

WACC - For a private company valuation, the cost of debt can be determined by examining the
subject company’s credit history and the interest rates being charged to the company. Equity can
be estimated using the capital asset pricing model (CAPM). The debt and equity ratings and the
cost of capital for comparable companies are also factored into WACC calculations. Beta section
can be referred to see how it can be calculated for private firms.

3) Asset Based Approach

The asset-based approach estimates the value of firm equity as the fair value of its assets minus the
fair value of its liabilities. It is generally not used for going concerns. Because it is easier to find
comparable data at the firm level compared to the asset level, the income and market approaches
would be preferred when valuing going concerns. Additionally, it is difficult to find data for
individual intangible assets and specialized assets. Of the three approaches, the asset-based
approach generally results in the lowest valuation because the use of a firm's assets in combination
usually results in greater value creation than each of its parts individually.

The asset-based approach might be appropriate in the following circumstances:

• Firms with minimal profits and little hope for better prospects. In this situation, the firm might
be valued more highly for its liquidation value rather than as a going concern by a firm that
can put the assets to better use.
• Finance firms such as banks, where their asset and liability values (loan and security values)
can be based on market prices and factors.
• Small companies or early-stage companies with few intangible assets. Natural resource firms
where assets can be valued using comparable sales.
Applying Discounts

Regardless of the method used for estimating the subject private company’s valuation,
several discounts need to be taken into consideration and applied where appropriate:

1) Marketability discount: This discount considers the lack of ability to rapidly

convert an ownership stake to cash.
2) Key man discount: This discount might not always apply; it depends on the nature of the
business. If the business is in a stable industry and already well-developed, losing a key
employee or leader might not have any impact. But if the company is young or there is a lot
of value associated with a particular individual, the impact of that person leaving could be
substantial. Apple provides the best example: After Steve Jobs was forced out of the
company, Apple experienced several disastrous years, only recovering after Jobs was brought
back onboard. The value of Apple without Steve Jobs was substantially less than it was when
he was leading the company.

3) Control discount: If a minority stake in a private company is sold, a value adjustment needs
to be made to account for this lack of operational and financial control. This can also apply in
a public company but will have a much smaller impact; the impact in private companies is
much more significant due to the lower level of transparency associated with private businesses.

Unlike other valuations, DCF relies on Free Cash Flows. To a larger extent, Free Cash Flows
(FCF) are a reliable measure that eliminate the subjective accounting policies and window
dressing involved in reported earnings.

Besides explicitly considering the business drivers involved, DCF allows investors to incorporate
key changes in the business strategy in the valuation model, which will otherwise not be
considered in other valuation models (like relative, APV, etc.)

While other methods like relative valuation are fairly easier to calculate, their reliability becomes
questionable when the entire sector or market is over-valued or under-valued. DCF cuts across
through this quandary and predicts the best possible intrinsic value.
Important Q/A

Q 1. What is Investment banking?

Ans 1.
The investment bank performs two basic, critical functions: acting as an intermediary for capital
raising, and as an advisor on M&A transactions and other major corporate actions.
An investment banker is in the business of raising money for companies, governments, or other
entities. The investment banker can work within a financial institution or for a division of a large
bank. Investment bankers will be involved with large and potentially complicated financial
transactions. They help shape financial deals to raise money for expansion, acquisition, merger or
sale of a business. This also includes the IPO of a company’s stock, as this is done to raise money for
the company to meet its objectives.
Commercial banks deal with individuals and small to mid-sized companies, giving out smaller sums
of money like individual mortgages and small business loans. They make their profits through the
interest they charge.
On the other hand, investment banks, take much larger risks. They deal with huge companies and
high-risk startups, acting as a bridge between companies and investors.
• Underwriting
• Financial restructuring
• General Pitch Book
• Deal Specific Pitch Books
• Investment Banking Job Hierarchy

Q 2. Accretive, Dilute EPS and Deal Structure, Rationale behind it. Explain accretion / dilution
and effect on P/E
Ans2.
Analysing whether a specific M&A deal is a valuable one with long-term growth prospects is a
complex undertaking that covers tremendous amounts of information and forecasting. An
accretion/dilution analysis helps decision-makers in the M&A process determine whether or not they
should proceed with a proposed deal.
An accretion/dilution analysis is a simple test used to evaluate the merit of a proposed merger or
acquisition deal. The accretion/dilution analysis determines if the post-transaction earnings per
share (EPS) is increased or decreased.
An increase in pro-forma EPS is regarded as an accretion, while a decrease is regarded as a dilution.
Simple test to check whether EPS increases or decreases post-merger. If there is synergies achieved
in the deal, there will be accretion.
Process:
1. Calculate each one’s net income
2. Calculate EPS for both the companies
3. Calculate post-merge, net income (combined)
4. Combine shares outstanding of both the companies
5. Use to find new EPS
6. If greater than the previous one, Accretion has happened.

An accretion/dilution analysis is not a composite of the complete picture, nor does it contemplate
how a newly combined entity operates, adjusts, or takes advantage of opportunities years down the
road.

Q 3. How will the financial statements be affected in a buy back?

Ans 3.
A share repurchase has an obvious effect on a company’s income statement, as it reduces outstanding
shares, but share repurchases can also affect other financial statements. However, note that buybacks
do not impact the income statement line items (i.e., it is not recorded as an expense), only the
published EPS figure reported beneath the net income.
On the balance sheet, a share repurchase would reduce the company’s cash holdings—and
consequently its total asset base—by the amount of cash expended in the buyback. The buyback will
simultaneously shrink shareholders' equity on the liabilities side by the same amount.

Q 4. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability.

What’s the difference between them, and when do you use each one?
Ans 4.
P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA are capital
structure neutral. Therefore, you use P / E for banks, financial institutions, and other companies where
interest payments / expenses are critical.
EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it – you’re more
likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed
assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less
important and where D&A is comparatively smaller (e.g. Internet companies)

Q 5. How do you value a private company?

Ans 5.
You use the same methodologies as with public companies: public company comparables, precedent
transactions, and DCF. But there are some differences:
1) You might apply a 10-15% (or more) discount to the public company comparable multiples
because the private company you’re valuing is not as “liquid” as the public comps.
 2) You can’t use a premiums analysis or future share price analysis because a private company
doesn’t have a share price.
3) Your valuation shows the Enterprise Value for the company as opposed to the implied per-
share price as with public companies.
4) A DCF gets tricky because a private company doesn’t have a market capitalization or Beta –
you would probably just estimate WACC based on the public comps’ WACC rather than trying
to calculate it.

Q 6. How do you value banks and financial institutions differently from other companies?
Ans 6.
For relative valuation, the methodologies (public comps and precedent transactions) are the same, but
the metrics and multiples are different:
1. You screen based on assets or deposits in addition to the normal criteria.
2. You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA
(Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value
rather than Revenue, EBITDA, and so on.
3. You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.
4. Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:
5. In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in
future years and then add it to the present value of the bank’s terminal value, usually basing
that on a P / BV or P / TBV multiple.
6. In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s
current Book Value and simply add the present value of the excess returns to that Book Value
to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book
Value) – basically how much the returns exceed your expectations.
You need to use these methodologies and multiples because interest is a critical component of a bank’s
revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book
values are usually very close to their market caps.

Q 7. Walk me through a Sum-of-the-Parts analysis.

Ans 7.
In a Sum-of-the-Parts analysis, you value each division of a company using separate comparable and
transactions, get to separate multiples, and then add up each division’s value to get the total for the
company. Example:
We have a manufacturing division with $100 million EBITDA, an entertainment division with $50
million EBITDA and a consumer goods division with $75 million EBITDA. We’ve selected
comparable companies and transactions for each division, and the median multiples come out to 5x
EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods.
Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company’s total
value.
Q 8. Why would you use Gordon Growth rather than the Multiples Method to calculate the
Terminal Value?
Ans 8.
In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s
much easier to get appropriate data for exit multiples since they are based on Comparable Companies
– picking a long-term growth rate, by contrast, is always a shot in the dark.
However, you might use Gordon Growth if you have no good Comparable Companies or if you have
reason to believe that multiples will change significantly in the industry several years down the road.
For example, if an industry is very cyclical you might be better off using long-term growth rates
rather than exit multiples.

Q 9. Walk me through a Dividend Discount Model (DDM) that you would use in place of a
normal DCF for financial institutions.
Ans 9.
The mechanics are the same as a DCF, but we use dividends rather than free cash flows:
1. Project out the company’s earnings, down to earnings per share (EPS).
2. Assume a dividend payout ratio – what percentage of the EPS actually gets paid out to shareholders
in the form of dividends – based on what the firm has done historically and how much regulatory
capital it needs.
3. Use this to calculate dividends over the next 5-10 years.
4. Do a check to make sure that the firm still meets its target Tier 1 Capital and other capital ratios –
if not, reduce dividends.
5. Discount the dividend in each year to its present value based on Cost of Equity – NOT WACC –
and then sum these up.
6. Calculate terminal value based on P / BV and Book Value in the final year, and then discount this
to its present value based on Cost of Equity.

Q 10. If I’m working with a public company in a DCF, how do I calculate its per-share value?
Ans 10.
Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock, and
noncontrolling interest (and any other debt-like items) to get to Equity Value.
Then, you need to use a circular calculation that takes into account the basic shares outstanding,
options, warrants, convertibles, and other dilutive securities. It’s circular because the dilution from
these depends on the per-share price – but the per-share price depends on number of shares
outstanding, which depends on the per-share price.
To resolve this, you need to enable iterative calculations in Excel so that it can cycle through to find
an approximate per-share price.
Q 11, Explain why we would use the mid-year convention in a DCF.
Ans 11.
You use it to represent the fact that a company’s cash flow does not come 100% at the end of each
year – instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year,
2 for the second year, 3 for the third year, and so on.
With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for
the third year, and so on.

Q 12. How does the terminal value calculation change when we use the mid-year convention?
Ans 12.
When you’re discounting the terminal value back to the present value, you use different numbers for
the discount period depending on whether you’re using the Multiples Method or Gordon Growth
Method:
• Multiples Method: You add 0.5 to the final year discount number to reflect the fact that you’re
assuming the company gets sold at the end of the year.
• Gordon Growth Method: You use the final year discount number as is, because you’re assuming the
cash flows grow into perpetuity and that they are still received throughout the year rather than just at
the end.