Valvation. Theories and Concepts. Rajesh Kumar. Professor of Finance, Institute of Management Technology, Dubai, UAE

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1 Valvation Theories and Concepts Rajesh Kumar Professor of Finance, Institute of Management Technology, Dubai, UAE ELSEVIER AMSTERDAM BOSTON CAMBRIDGE HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY" TOKYO Academic Press is an imprint of Elsevier

2 Contents Preface Acknowledgments xv xvii Part I Theories and Concepts 1 1 Perspectives on value and valuation Introduction Application of valuation Approaches to valuation Steps in value creation Value drivers Empirical evidence on value drivers Strategie models of valuation Stock price maximization Linkage between Strategie management and shareholder value Challenges in valuing intangibles Innovation and value creation Review of research studies on usage of valuation methods Challenges for valuation Review on theories of valuation Most valuable companies 27 Appendix: Financial Statement analysis 27 Analysis of growth potential 33 Fundamentals of valuation 35 Bond valuation and interest rates 38 Basics of stock valuation 42 Summary Highlights of stock valuation 43 References 44 2 Risk and return Introduction Accounting and risk measures Measures of returns Riskpremium Models of risk and return 58 References 71

3 viii Contents 3 Efficient capital markets and its implications Introduction Forms of efficient market hypothesis Tests ofemh Review of research studies on market efficiency Anomalies of EMH Implications of EMH Behavioral finance 87 References 88 4 Estimation of cost of capital Introduction 93 References Principles of cash flow estimation Introduction Adjustments to financial statements Adjustments of expensed Investments Reflections on managed earnings Estimating reinvestment needs for valuation Forecasting growth 133 References Discounted cash flow valuation models Introduction Dividend discount model FCF valuation models Adjusted present value method Value of nonoperating assets Estimation of total value of firm Theoretical perspectives on free cash flow valuation Research studies on FCF models Estimation of value of Hyundai Motors through FCFE and FCFF valuation models Estimation of value of Sasol through the two-stage FCFF model 179 References Relative valuation Introduction Advantages and disadvantages of relative valuation Drivers of relative valuation Steps in relative valuation Relative valuation techniques Industry-specific multiples Research studies on relative valuation 197

4 Contents ix 7.8 Principles of relative valuation Cases of relative valuation 200 References Mergers and acquisitum valuation Introduction Types of mergers and acquisitions Synergies in mergers Drivers of value creation in different types of M&A Empirical evidence on value creation in M&A M&A valuation Valuation of M&A synergies Payment to target firms Bootstrapping Empirical studies involving methods of payment Empirical studies on Performance of merged companies Principles of evaluation of bids Illustration of financial variables in merger analysis 222 References Real options valuation Introduction Real options as Strategie Investments Limitations of discounted cash flow methods Different types of real options Solution approach to option valuation Real options in different industry sectors Factors affecting the value of real growth options Real options in mergers and acquisitions Empirical studies on real options Real option valuation using decision tree approach Real option valuation using Black Scholes model 235 References Valuation of different industry sectors Valuation of internet companies Valuation of financial institutions Valuation of biotechnology companies Valuation of real estate and construction sectors Valuation of oil companies 252 References Valuation issues Valuation of closely held or private companies Valuing firms with negative earnings 256

5 X Contents 11.3 Valuing cyclical firms Valuing startup firms Valuing multibusiness firms Valuation in emerging markets Valuing high growth companies Errors in valuation 260 References 260 Part II Case Studies on Valuation Valuation of Walmart Financial highlights Equity value creation Ratio analysis Standardized income statements of Walmart Valuation of Walmart Discounted cash flow valuation Two stage FCFE model Relative valuation 288 References Valuation of Tata Motors Global industry trends Business overview Competitor analysis Financial Performance analysis Wealth creation in stock market Ratio analysis Estimation of cost of equity and WACC Valuation of Tata Motors Valuation using dividend discount models FCFE valuation Stahle stage or constant growth model Valuation using FCFF model Relative valuation 304 References Valuation of Samsung Electronics Strategies for growth Growth trend analysis Ratio analysis Stock market wealth creation Discounted cash flow valuation Estimation of cost of equity and cost of capital 316

6 Contents xi 14.7 Dividend discount model Constant growth DDM FCFE valuation Estimation of adjusted net capital expenditure Estimation of noncash working capital in millions of krw Estimation of two stage FCFE valuation Constant growth FCFE model Zero growth FCFE model FCFF valuation model Two stage FCFF valuation model Stahle phase inputs FCFF one stage growth model FCFF zero growth model Relative valuation Valuation of Industrial and Commercial Bank of China (ICBC) Business segments Strategy Growth analysis Stock market wealth creation Valuation of ICBC DDM Relative valuation 345 References Valuation of Gazprom Growth rate analysis Ratio analysis Stock wealth creation Estimation of cost of capital WACC estimation Valuation using discounted cash flow valuation FCFE valuation Relative valuation 361 References Valuation of Singapore airlines Growth rate analysis Ratio analysis Stock wealth creation Excess value added Estimation of cost of capital Valuation models Stahle stage dividend discount model 373

7 17.8 Stahle stage FCFE and FCFF models Estimation of FCFE in year Estimation of FCFF Relativevaluation Enterprise value multiples 375 Reference Wells Fargo Current financial Highlights Financial Highlights Growth analysis Stock wealth creation Dividend discount model Estimation of growth rate from fundamentals Relative valuation 385 References Valuation of China life insurance Financial Highlights Solvency ratio Gross written premium Analysis of cash flows Estimation of embedded value Stock return analysis Estimation of cost of equity Discounted cash flow model Relative valuation 394 References Valuation of Franklin resources TypesofSIPs Types of Investment management and related services Investment products Stock wealth creation Estimation of cost of equity Valuation Stahle phase inputs Relative valuation 408 References Valuation of Pfizer 21.1 Growth perspective of Pfizer 21.2 Performance analysis

8 Contents xiii 21.3 Stock wealth creation Estimation of cost of equity and WACC Valuation models Relativevaluation 426 Reference 428 Part III Case Studies on Mergers and Acquisition Valuation Google's acquisition of Motorola a valuation perspective Introduction Merger Highlights Strategie reasons for the acquisition Financial breakdown of Motorola deal Valuation perspectives Returns analysis for different time windows of acquisition announcement Cumulative abnormal return analysis Valuation operating Performance analysis Two-stage valuation model for Motorola Mobility Zero growth or perpetuity model valuation for Motorola Relative valuation for Google Inc Cash flow to market value model 445 Appendix 1: Cumulative returns for Google Inc. 451 Appendix 2: Cumulative returns for Motorola Mobility Holdings 451 Appendix 3: Cumulative abnormal returns (CAR) for Google Inc. 452 Appendix 4: Cumulative abnormal returns (CAR) for Motorola Mobility Holdings 453 References HP Compaq merger valuation Industry overview Company Highlights Merger Highlights Expected synergies Impact of merger announcement on wealth creation 458 Reference Tata's acquisition of Corus a valuation analysis Highlights of Corus Highlights of Tata Steel The bidding war 464

9 xiv Contents 24.4 Market reaction during the Requisition process Strategie reasons for the Requisition Valuation perspective 467 References 471 Glossary Index

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