NISM 15 Chapter 10: Valuation Principles & Models | Notes by Dhaval Visariya

NISM Series XV - Chapter 10: Valuation Principles

"Price is what you pay, Value is what you get." Chapter 10 teaches us how to calculate that "Value." Because the future is uncertain, valuation is more of an art than a science, but we use mathematical frameworks to minimize error.

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1. Three Approaches to Valuation

1. Cost-Based: What does it cost to "build" this company from scratch? (Rarely used by retail investors).

2. Cash Flow Based (Intrinsic): Value is the Present Value of all future cash flows.

3. Selling Price Based (Relative): Value is based on what "similar" companies are trading for (e.g., comparing HDFC Bank to ICICI Bank).

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2. The DCF Model (Absolute Valuation)

The Discounted Cash Flow (DCF) model is the "Gold Standard." It assumes a business is worth the sum of its future cash flows, discounted back to today's value.

A. Dividend Discount Model (DDM)

Best for mature, stable companies that pay regular dividends.

• Gordon Growth Model Formula:

  $$P = \frac{D_1}{k - g}$$

  (Where $P$ = Fair Price, $D_1$ = Expected Dividend, $k$ = Cost of Equity, $g$ = Growth Rate)

B. FCFE vs. FCFF

• FCFE (Free Cash Flow to Equity): Cash left for shareholders after all expenses, reinvestment, and debt repayments. Discounted using Cost of Equity ($K_e$).

• FCFF (Free Cash Flow to Firm): Cash available to all capital providers (Debt + Equity). Discounted using WACC.

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3. The Math Behind the Discount Rate

To discount future money, we need a rate that reflects risk.

The CAPM Formula (Cost of Equity)

Used to find the return an equity investor expects:

$$K_e = R_f + \beta \times (R_m - R_f)$$

• $R_f$: Risk-Free Rate (usually Govt Bond yield).

• $\beta$ (Beta): Sensitivity of the stock to market moves.

• $R_m - R_f$: Market Risk Premium.

WACC (Weighted Average Cost of Capital)

The average cost of all funding sources (Debt and Equity).

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4. Relative Valuation (Multiples)

Since DCF requires many assumptions, analysts often use Multiples to see if a stock is "relatively" cheap.

Metric	Formula	Best Used For...
P/E Ratio	Price / EPS	General profitable companies.
PEG Ratio	PE / Growth Rate	High-growth companies (PEG < 1 is undervalued).
P/BV Ratio	Price / Book Value	Banks and NBFCs.
EV/EBITDA	Enterprise Value / EBITDA	Capital-intensive firms (Steel, Cement).
EV/Sales	Enterprise Value / Sales	Startups or loss-making companies.

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5. Specialized Valuation Metrics

• Sum-Of-The-Parts (SOTP): Used for conglomerates (like Reliance or L&T) where you value each business division separately and add them up.

• Embedded Value (EV): The specific metric for Life Insurance companies.

• Net Asset Value (NAV): Used for asset-heavy businesses like Real Estate or Shipping.

• EV/Capacity: Valuing a company based on its production capacity (e.g., "Price per ton" for a Cement plant).

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Dhaval’s Study Tip for Chapter 10:

This is a high-scoring chapter if you know the formulas!

1. Memorize the Gordon Growth Model.

2. Understand CAPM – it appears in almost every NISM 15 exam.

3. Remember: Use $K_e$ to discount FCFE, and use WACC to discount FCFF.

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Dhaval Visariya

AMFI Registered Distributor (ARN-327925) | Software Developer & Finance Enthusiast

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