Business Valuation with Special Emphasis to Derivative Financial Instruments

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Business Valuation with Special Emphasis to
Derivative Financial Instruments

• CMA Gautam Mitra
• Burdwan University, West Bengal

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Q. X is willing to invest in index future market
lot is 200 units. Spot price of 1 unit is Rs.
1,100 margin money is 10 bank interest rate is
9 three months index future is Rs. 1,122. Take
investment decision.
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Definition

• Valuation is not an objective exercise, any
  preconceptions and biases that an analyst brings
  to the process will find their way into value.

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Price v/s Value

• A lawyer buys a book for Rs. 40,000 in order to
  perform an assignment having remuneration of Rs.
  2,50,000. After reading the book he found it
  useless. What is the value of the book ?
• An oil reserve of Petronet LG finds that oil
  price is Rs. 70 per barrel whereas extraction
  cost per barrel is Rs. 110, again what is the
  value of oil to the company ? Again what is the
  value, when oil price reaches to Rs. 130 ?

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Foundation of Business valuation

• Investor does not pay more for an asset than it
  is worth. He should not buy most assets simply
  for aesthetic or emotional reasons. Asset price
  can not be justified only on the argument that
  there are investors around who will pay a higher
  price in future.

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Why Valuation ?
Purpose of valuation Examples
Transactions MA, Reverse merger, IPO, ESOP, Buyback of share
Court cases Bankruptcy, Divorce cases, Intellectual Property Disputes
Compliances Fair value accounting(IFRS 13), Tax issues
Planning Estate planning, personal financial planning, MA planning
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3 Approaches to Business Valuation

• DCF
• Relative Valuation
• Contingent claim valuation

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Uncertainties in Business Valuation

• Macroeconomic factors
• The Business
• Growth potential in the industry in which it
  operates
• How is the business positioned ?
• Who are competitors ?
• What is the quality and stability of the
  management ?

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Principles of Valuation

• Substitution- Business A can be sold at X amount.
  If a similar business is available at a price
  lower than X then business A has worth less
  than X amount.
• Alternatives- No single decision maker should be
  confined to considering a single
  transaction. He must consider several
  alternatives.
• Time Value of Money- Getting appropriate discount
  rate could be debatable issue and may
  have estimation bias.
• Expectation- Future valuation of a project by a
  company like LT may be well expected well
  before maturity, however for
  new companies it might be very difficult to
  predict extent and
  direction of growth.
• Risk and Return- Harry Markowitz model was first
  to quantify risk and derive optimal portfolio.
  Markowitz model assumed (i) Investor is risk
  averse (ii) He prefers greater wealth for higher
  consumption (iii) Given two portfolios
  of similar risk one would chose a portfolio with
  higher expected return. These assumption
  constitutes integral part of valuation exercise.
• Reasonableness and Reconciliation-
• 1. Inconsistency in judgement and assumptions.
• 2. Conceptual Flaws
• 3. Projection modelling and formula errors

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Myths about valuation

• A valuation is an objective searched for true
  value.
• Valuation models are quantitative and greater the
  inputs better is the result.
• A well researched an well done valuation is
  perpetual in nature.-When the facts change, I
  change my mind and what do you do, Sir?-John
  Maynard Keynes
• 4. A good valuation provides a precise estimate
  of values-the pay off to valuation is greatest
  when valuation is least precise.
• A valuer should assume that markets are
  inefficient-in an efficient market value is
  equal to price.
• Value matters and not the valuation- ignored
  points
• 1. brand name
• 2. return on project
• 3. appropriate price on high growth.

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Valuation of Stock index future

• 1. Consider a three months future contract on
  NIFTY. Assume that the spot value of the index is
  Rs. 1,090. Discrete rate of interest is 12 per
  annum. Discrete rate of yield on shares
  underlying NIFTY is 6 per annum. Multiplier is
  200(market lot). Compute the values of one future
  contract

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Option Valuation
S (Rs.) K (Rs.) T (yrs.) s
120 115 .25 0.6 0.1