0:09

welcome

back we are going to do a mega

example and the reason for doing this mega example is

so that if you internalize this you’ll know all the

steps involved in just about any valuation exercise

as I said I don't talk about multiples a lot

but we will do a small sectional which will help you understand that multiples

are just a reflection of discounted cash flows actually a very simple

way of thinking about it and very powerful too because it’s simple let's

start with an example

and the focus of this example will be

how do you get your discount rates and

in three valuation methods so step number one

some information and I would pause so that you can write it all down

but let's go methodically suppose sears wants to go online

and has identified bears as the comparable

sorry for my lack of sense of humor but what can you do

you know you can just try harder that’s all suppose the beta of equity

of bears is one as you are noting this down please

think through and this is very important with problem solving why am i

giving you beta equity is a closer to real life to give you beta equity or

beta assets and so on

suppose sears wants to go online bears is the comparable

as soon as I give you one comparable you should say why didn't Gautam give me

more

but the more the process for each one of them

will be the same the beta of equity of bears is about 1

and now when I say beta equity

is that what you want start thinking like that

okay so suppose it's 1 why have I chosen 1

because I make want to make my life simple will it ever exactly be 1

no there’ll always be some decimals in there okay

and carry them with you even if I don't because decimals are important

even a little bit of change in returns can make a huge difference because of compounding

ok now the market value of bears

equity is 120 billion dollars and the riskless debt

which it has is about $30 billion so why did I

give you these two pieces of information because I'm telling you

that these are the pieces of information you actually can go and get

so if bears was traded you’ll put in its

symbol on finance dot yahoo dot com you'd go to key statistics

and beta equity would be right there and the balance sheet would

show the debt book value of $30 billion

and the market value of equity is just price times quantity it’ll be given

right but you can take price per share times

number of shares okay so that's the beauty of markets

that actually you do have a comparable and

the challenge in not having a comparable is when you do something new

that's when mispricing occurs in IPOs

a lot right because people don't know how to price it

nobody knows how to do things until we have done them

and remember the reason for that is all valuation is

relative not absolute okay

risk-free rate is 2 percent and market risk premium is 5 percent

so as soon as you read this information and please write it

as we are talking and I'll leave the for about a few seconds

I’ll keep that slide up because

it’s good for you to get this information okay

so 2 percent is the risk free rate and market risk premium is 5 percent

ok what strikes you as you're reading this

something should strike you okay but

just let's keep going what is market risk premium

the difference between the expected return on the market

minus the risk-free rate and by the way this is very controversial

this is one of the most important variables

in finance and life because it enters the discount rate

and discounting is what humans do all the time and five percent

may be too high many people are now using 2 or 3 percent

so I'll keep talking about that as we move along let's

keep it at 5 here for convenience the corporate tax rate is

34 percent so have I given you information about the comparable just

stare at it and

let it sink in quickly your comparable is bears

Bears beta equity is 1 bears equity is 120 billion

bears’ debt is $30 billion albeit book value but you can’t do better

risk-free rate 2 percent and risk premium 5 percent

tax rate 34 percent so taking this information what do you want to get

remember you go to a comparable to unlever

if there is debt is there debt here yes

so I want to unlever it so let's start the process

approach one of unlevering what will you do

so let's first calculate return on assets

using this approach because you can also calculate what

beta asset okay let's use this approach to do this but in the first approach

always remember what is the assumption

in our first approach assumption is tax shield

which is there because the comparable has debt the discount rate for it

will be Rd we won't go through all the steps of deriving the equation we’ll

just plug and chug

okay ok

so Ra

will be equal to Re

E over I'm gonna go slow

D 1 minus TC

plus Rd I mean sorry plus E

I don’t know what I'm thinking I'm one step ahead

so this thing here and let me try something cool

okay so

wasn’t that cool yeah okay

so 1 minus TC this is a T

plus E times Re

which is done Rd

D 1 minus TC

over D 1 minus TC

plus E

so this is the equation we are working with but what don't we have here

we don't have Re we do know Rd

we do know D we do know E we know

TC okay with me so

how do we do this do we know E answer is yes

how much is it I think it is 120 billion dollars

how much is d

30 how much is this

.34 how much is this

120 so on and so forth

so you know we know all these numbers do we know

Rd I said we do

but I'll give you a second think about it I haven't given you Rd but I've

given you a

big hint the beta

of debt will be what for bears

it says it’s riskless debt so Rd will be equal

to 0 no 2 percent

what will be zero beta debt

why because it's debt is risk free

so you see when you’re speaking fast you make the mistake of

thinking you know what you're talking about and I believe

the return on risk-free rate was 2 percent and because you have

risk free debt

you better have the same return as the risk free rate otherwise you are creating a

money-making opportunity so the only number that's not there by now

you should know is Re though the Re

Rd example is very neat because I didn't give you the number but I gave

you a hint

and this happens in life and it saves you a lot of time to think before you

jump

so how do you do Re

do you have the beta equity answer is yes

which model will you use you will use

CAPM

so what will Re be and I'm going to typically there’ll be expected Re but

I'm going to leave those out

Rf plus

9:16

fair enough this is your comparable beta equity

how much is this 5 percent

how much is this 2 percent let me just pause here for a second and say this

example is very simple in terms of numbers

but the methodology is what you want to focus on

the numbers are simple so that we you know you can get

moving fast the second question beta equity

do not pull from Yahoo Finance try to be very

make sure you’ve the best beta for this

business and Morningstar is a great company other companies also do this

very well

but it’s statistical beta is a statistical

number so Re is seven-percent are we in business now

yes so to make sure we have everything going right

let’s start I will substitute all the numbers

7 percent for here

2 percent for here D what let's go through it again

this is 30 .34

120

when you do that you will figure out Ra

will work out to be 6.3

6.3 percent please

take a while and do it once I'm done I'm not going to walk through the steps I’ve just

put in all the numbers so 7 percent times 120

divided by 30

times .34 subtracted from one

plus 120 and so on so just very quickly if you do this

you'll be able to get exactly what I have done here and you’ll get 6.3 percent

but what is 6.3 percent the return on

the business

of that’s your comparable there

one more step and then we'll take a little break so we have done

return on assets and it’s 6.3 percent

I have given all the numbers and I would really encourage you to kinda do the

mechanical calculations to make sure 6.3 is right

every time you have a debt number on the right hand side

please remember that it has to be multiplied by 1 minus TC

let's now do for complete for

getting a complete picture of it and let's do

beta assets

remembering we are still in approach one

so return on asset is 6.3 percent

what is the comparable beta asset remember

going through the steps again beta asset the neat

thing is

all these things that I'm writing

are basically the same right

beta debt actually plus

E over D 1 minus

TC plus E beta

equity so I'm saying now let's go through these steps and see if we can figure out

what beta asset is for our comparable

using approach one do I know D

yes do I know E yes do I know TC yes

so .34

120 30

those are the three numbers again 120

30 .34

do we know beta equity did I give you this beta equity or not

the answer is yes beta equity was

one right

where did we use this beta equity earlier

we used this beta equity through CAPM to get a return on asset

which was about I mean return on equity which was about 7 percent

I think I'm slipping up today for some reason asset equity I’m

confusing the two okay but the challenge here

is to figure out beta debt which we already have figured out

and it’ll be 0 so the answer to this will work out to be

.86

the reason I can do it so easily is because I've done it already

just so that you know the way I know it’s .86 is I’ve

done the rates and this is zero so that tells me also

what is this rate going to be if I’ve calculated it

right .86

then what will this rate be

point .14 key to remember

very very common in our applications in books

in student thinking they think this is always true

and what is this that the beta of debtis 0

this is derived from the assumptions made I think I’ve

told you this and Modigliani-Miller which is the basis of

a lot of finance that at some point made an assumption for ease

that suppose that all debt is risk-free

and therefore beta debt disappeared from the equations and therefore

you know a lot of people assume that's always true not true

we know how to do beta asset and beta equity

approach which one one

Re 6.3 beta Ra 6.3

beta a .86 watch me today

my language is going flip flop sometimes okay

so let's do now next approach

two what is the return on asset using approach two

now this is becoming a little bit repetitive

but it's very careful to know both methods the method two what is the assumption

method two the assumption is tax shield is using what as the discount rate

Ra so let’s write out Ra

Ra is equal to D over D plus E and now I feel good

because there's no 1 minus TC floating around Re

plus E over D plus E

Rd yes cool

have I screwed up something yes I did

I'm today going back and forth

between these Rs for some reason okay so

if I’m doing it fast at least I’m catching it so every time you have a proportion of debt

you should have a return on

debt and so on why does this equation work we have

done that that's a proof we've done already let's plug and chug

30 30

120 120

30 120

okay so which has more weight clearly

more weight is on equity right we knew that

what is Rd we already went through the process of realizing that beta debt is

zero the

Rd has to be the risk-free rate what is Re

Re was

7 percent how did we get that

beta equity was one in CAPM and so on

so these are just essentially the weights are changing

because of the assumption of the tax deductibility

the weights are 80 20 here and they were 86

14 earlier what does this number work out to be

well this number works out to be 6 percent

please confirm that this is true and if you hear a little paper

rustling it’s me confirming that this is true

okay so we have done return on assets

its lower a little bit 6.36 percent

okay let's beta of assets using this approach

beta of assets using this approach is pretty straightforward

D over D plus E beta D

plus E over D plus E

beta E what do we know in this equation

well we know that this is 20 percent

this is 80 percent 120 divided by

150 I think is 80 percent or point 80

what is this 0 what is this 1

how do we know that we've already given it can we figure it out for bears

ourself

yes by estimating it using regression

methodology this turns out to be .8

so I'm going to take a pause but before

I do so I’ll remind you that there are two pairs of

Ras and beta As approach one

approach two and what are the pairs

6.3 percent Ra

with the beta a .86

6 percent with the beta of

.8 approach two approach

one does this make sense

always ask yourself equations are all fine I know the logic blah blah blah but

the numbers should make logic too and the answer is I think they do

why because as the beta increases

what happens to the return the return also goes up

and why are they different they are simply different because of the

assumption about the discount rate for the tax shield

let's take a break and when we come back

we will take all this information and actually do some fun

valuation