NISM RA Chapter 10 — Valuation Principles: DCF, CAPM, WACC and every multiple that matters
This is my note on Chapter 10 of the NISM-Series-XV Research Analyst workbook — “Valuation Principles.” Twelve marks, heavily numerical, and the partner to Chapter 8 in deciding most people’s result. Chapter 8 taught you to read what a business has done. This chapter teaches you to put a number on what it is worth. Every formula here needs practising, not just reading — so I’ve worked through the case-study math at the end.
Price is not value
The chapter opens with two quotes that frame everything. Seth Klarman: in capital markets, price is set by the most panicked seller, while value is determined by cash flows and assets — and the challenge and opportunity of investing is to find the greatest divergence between the two while resisting the crowd’s extreme emotions. And Buffett’s compression of the same idea: “Price is what you pay and value is what you get.”
The practical distinction: price comes from the stock market and is known to everyone; value is the product of one valuer’s analysis at one point in time. There is no formula that throws out a precise number, because the inputs themselves are uncertain. The output is at best an educated estimate after adequate due diligence. Hence the line that recurs through the chapter: valuation is an art as much as a science, requiring knowledge, experience and professional judgment.
Why valuations are done
Six reasons the workbook lists: buying a business as an investment exercise; selling one; mergers and acquisitions; giving owners a general sense of value; ensuring fair treatment of different stakeholders in an equity swap; and accounting, taxation and other regulatory or legal requirements.
Whatever the objective, the purpose is to relate price to value and judge whether an asset is fairly priced, over-priced or under-priced. And because of the limitations, valuers typically present multiple scenarios showing how the output changes when the primary variables change.
The two sources of value
Buffett again: “There are only two sources of value in a business — earnings and assets.”
Every asset generates two streams: periodic earnings and a final inflow on sale. Bonds pay coupons and then redeem. Equities pay dividends and then get sold. Real estate pays rent and then sells at an appreciated capital value. Businesses exist for the same reason — to generate earnings, with the potential to realise cash from selling tangible and intangible assets if earnings aren’t sufficient or die away.
A revealing observation: lenders think identically. A lender first checks whether the business can generate cash flows to meet its obligations; collateral is not the primary consideration but a fall-back if the cash-flow estimate proves wrong. They want to be paid from cash inflows.
And the sobering caveat: the capability of business assets to pay off all liabilities and still settle equity holders is always doubtful — assets may be worth far less than their balance-sheet carrying value, while outstanding liabilities must be settled in full.
The three approaches to valuation
(i) Cost-based valuation — value an asset by what it would cost to create it. Suitable only for a buyer choosing between buying versus making. Most stock-market investors have no option to build and run a company themselves, so this is generally unsuitable for financial investors — though strategic investors intending to run the business long term may use it. It usually needs technical assessment by engineers.
(ii) Cash-flow-based valuation (intrinsic valuation) — value an asset by what an investor would pay for the cash flows it generates, by discounting those cash flows at a rate reflecting the investor’s required return. It splits into two:
- Risk-neutral valuation — adjust the cash flows by the probability of realising them, then discount at the risk-free rate. This is how insurance companies are typically valued (embedded value and appraisal value).
- Real-world valuation — estimate the most likely cash flow and discount at the risk-free rate plus a suitable risk premium for the uncertainty.
(iii) Selling-price-based approach (relative valuation) — value an asset from the prices of other similar assets, using ratios like P/E, P/B, EV/EBITDA.
The DCF model
Start with the bond intuition. A bond paying 9% annually, redeeming at ₹1,00,000 face value after 10 years, when prevailing rates for that maturity and credit quality are also 9%: the value is the present value of all future cash flows discounted at 9%, and because coupon and discount rate are identical, the answer is exactly the face value, ₹1,00,000. If investors demand more than 9%, the bond is worth less than ₹1,00,000; if they demand less, it’s worth more. (That inverse relationship is the workbook’s sample question 1 — if interest rates rise, bond prices fall.)
Every asset and liability is priced the same way. Replace the bond with equity, and coupons become dividends while redemption value becomes expected sale proceeds. The difference — and it’s the whole difficulty of equity valuation — is that with bonds both the quantum and timing of cash flows are known with certainty, while with equity both are unknown and uncertain.
The DCF approach is conceptually most appropriate when three things are known with certainty: the stream of future cash flows, the timing of those cash flows, and the expected rate of return (the discount rate). Given those three, it’s simple present-value mathematics.
For a business: find the inflows over outflows at different points in time — the Free Cash Flows (FCF) — and bring them to today at an appropriate discount rate. The two principal drivers of a DCF valuation are therefore estimating the expected cash flows and determining the discount rate — and valuations differ across analysts precisely because these two estimates differ.
The three DCF models
Dividend Discount Model (DDM) — discount expected future dividends at the cost of equity. Suitable for companies paying regular and substantial dividends, hence best for mature companies in defensive industries. Complications: equities have theoretically perpetual life, and dividends aren’t contractual — so estimates and assumptions are unavoidable.
The Gordon growth model (perpetual growth model) values a dividend-payer whose dividend grows perpetually at a constant rate:
P = D₁ ÷ (k − g)
where D₁ is the dividend expected at the end of the year, k is the cost of equity and g the constant growth rate. The essential assumption: g must be lower than k. (And cost of equity is taken as shareholders’ required return under the stringent assumptions of no information asymmetry and perfect capital markets.)
Free Cash Flow to Equity (FCFE) — DDM fails for companies that pay no dividends, and even strong performers may retain everything for reinvestment (the workbook’s example: Alphabet, Google’s parent, has never paid a dividend). FCFE values equity by discounting the free cash flow available to equity holders instead of dividends actually paid. Build it from the cash flow statement:
Operating cash flow − Capital expenditure − Interest payments ± Net borrowings / (repayments) = Free Cash Flow to Equity
FCFE is most useful for companies in a high-growth phase — but then you cannot assume a constant growth rate, because the current growth is likely unsustainable and may even exceed the cost of capital. So you value in two stages:
Value of equity = PV of FCFE during the high-growth phase + terminal value (the perpetual stream of FCFE after it)
Practically: assess how long high growth lasts, estimate FCFE for each of those years and discount them; then use the Gordon growth model on the post-maturity stream (with FCFE in place of dividends). And the step people forget: the terminal value itself must be discounted back to present value.
Free Cash Flow to Firm (FCFF) — FCFE’s weakness is that unless a company has an objective debt policy, net borrowings can’t be estimated objectively, and arbitrary assumptions bias the valuation. FCFF avoids this by measuring free cash flow before any cash flows relating to any source of capital:
Operating cash flow − Capital expenditure − Tax benefit on interest payments = FCFF
Or by the indirect method:
FCFF = EBIT × (1 − tax rate) + Depreciation & non-cash charges − Increase (＋ decrease) in non-cash working capital − Capital expenditure (＋ sale of assets)
Besides depreciation, other non-cash charges added back include amortization of capital expenses and loss on sale of assets; gains on sale of assets are deducted from both FCFF and FCFE.
Because FCFF is available to all capital providers, it is discounted at the WACC. Then, to get from firm value to shareholders’ equity, subtract minority interest, preferred share capital and interest-bearing debt. And to arrive at enterprise value, deduct surplus cash, cash equivalents and short-term investments not required for current operations.
Like FCFE, high-growth companies get the two-stage treatment.
Terminal value — two ways
Perpetual growth method — and here’s the discipline that matters: the perpetual growth rate is capped at the long-term nominal GDP growth rate of the markets the company operates in, because no business can grow faster than the economy forever. Analysts may use something lower if appropriate.
Exit multiple method — take the expected sale value at the end of the high-growth phase by multiplying EBITDA (or EBIT) at the end of that period by an appropriate EV/EBITDA (or EV/EBIT) multiple, with the multiple chosen from comparable firms.
Either way, the terminal value is added to the projection-period cash flows and discounted to present value.
The discount rate: CAPM and WACC
The discount rate must reflect the risk in the cash flows. FCFF is discounted at WACC (to value the firm); FCFE is discounted at the cost of equity (to value the equity). Cost of debt is normally taken as prevailing interest rates for borrowers of comparable credit quality; cost of equity is the return required by common shareholders.
Cost of equity comes from the Capital Asset Pricing Model (CAPM), which relates risk to expected return through three components: the risk-free rate (Rf), the expected market return (Rm), and beta (β) — the proxy for the firm’s systematic risk, reflecting both business and financial risk, measuring the sensitivity of the stock’s return to the market’s return.
Ke = Rf + β × (Rm − Rf)
where (Rm − Rf) is the market risk premium, and β × (Rm − Rf) is the equity risk premium compensating the investor above the risk-free rate.
Then:
WACC = [Ke × Equity ÷ (Equity + Debt)] + [Kd × (1 − Tax) × Debt ÷ (Equity + Debt)] = (Ke × We) + (Kd × (1 − Tx) × Wd)
Note the (1 − tax) on the debt side only — interest is tax-deductible, so debt’s effective cost is lower. Discounting the free cash flows at the appropriate rate gives the enterprise value or the value of equity as the case may be. And the closing warning: DCF valuations produce erroneous output if sufficient rigour doesn’t go into estimating the cash flows and the discount rate.
Relative valuation — the practical alternative
DCF is complicated and assumption-heavy. Since the purpose of valuation is to judge whether a business is overpriced, underpriced or fairly priced, we can skip absolute value and simply compare what we pay (price) with what we get (earnings and assets). That won’t give absolute valuation, but it gives a reliable sense of cheap or expensive.
Earnings-based multiples
Dividend Yield and Price-to-Dividend. Dividend Yield = DPS ÷ Current price. The workbook’s table for a company paying ₹5 dividend:
| Price | Dividend | Div. Yield | Price/Div |
|---|---|---|---|
| ₹50 | ₹5 | 10.00% | 10 |
| ₹100 | ₹5 | 5.00% | 20 |
| ₹150 | ₹5 | 3.33% | 30 |
| ₹200 | ₹5 | 2.50% | 40 |
The price-to-dividend ratio measures what the market pays for a rupee of dividend. At ₹50 the stock yields 10% — and compared against a bond yielding 10% pre-tax, which at a 30% tax rate leaves about 7% post-tax, the equity’s 10% looks compelling, plus it carries upside if earnings grow (upside a bond lacks, since debt redeems at face value). At ₹200 the 2.5% yield is inferior to the bond, and 40× price-to-dividend is expensive.
The general rule: when equity yields exceed bond yields, equity is cheap — typically true when markets are down; in bull markets equity yields fall well below bond yields.
But the crucial caution: a stock yielding more than its peers may not be a value pick — a high dividend payout may indicate limited avenues for expansion and investment, which limits capital appreciation. Which introduces a concept worth remembering by name: companion variables — the related company fundamentals you must check alongside a market-determined metric. P/E relates to the growth rate and ROE; EV/EBITDA relates to return on investment. Checking the companion variable is how you tell an genuinely underpriced stock from one cheap for good reason.
Earnings Yield and P/E. Earning Yield = EPS ÷ Current price, and its reciprocal is the famous P/E = Current price ÷ EPS. (Both are workbook sample questions — earnings yield on a ₹195 stock with ₹13 EPS is 13/195 = 6.67%.)
P/E indicates the money an investor must invest to receive one unit of profit. Computed on historical EPS, or as forward P/E on forecast EPS. Investors pay a higher price for earnings when they expect above-average growth or a turnaround.
All else constant, a higher P/E than the peer group and market means expensive; a relatively low P/E means undervalued. But — companies with higher growth potential or lower risk should trade at a premium, and those with lower growth or higher risk at a discount, so the analyst must factor these in. Also a technical point: earnings cover a period while price is at a point, so the period of reference for EPS must be appropriate. Since investors assess future potential over past performance, forward earnings dominate — but the choice of which future year is subjective, and analysts must judge (if the current year’s EPS is unusually low or high, comparing on next year’s expected earnings may be more sensible).
PEG Ratio. PEG = (Price ÷ EPS) ÷ Growth rate — the P/E divided by the growth rate. Coined by Peter Lynch, who believed a high P/E can be justified by high growth potential, while warning that high-growth regimes may not last long. His rule of thumb: PEG below 1 suggests undervalued.
The workbook’s example: A Ltd has EPS ₹10 at a price of ₹120 (P/E 12x); B Ltd has the same EPS at ₹140 (P/E 14x). On P/E alone, A looks better. But if A grows at 10% and B at 15%, then A’s PEG is 12/10 = 1.2x and B’s is 14/15 = 0.93x — factoring growth in, B is the better investment. That reversal is exactly what the exam likes to test.
EV/EBIT and EV/EBITDA. Because equity is the residual claim, its returns are affected by capital structure — so EPS, and therefore P/E and PEG, are impacted by capital structure. A retail investor can’t change that, but a controlling shareholder can — so from an acquirer’s perspective, a capital-structure-neutral ratio is more suitable. Hence, when valuing a company as an acquisition target, use EV/EBIT or EV/EBITDA.
Both are neutral to capital structure. Choosing between them: in capital-intensive industries, differences in historical asset cost and depreciation method create big discrepancies, so EV/EBITDA is preferable; for other industries, EV/EBIT is preferable. As with P/E, lower is more attractive all else equal, but higher growth or lower risk attracts a premium.
EV/Sales. P/E, EV/EBIT and EV/EBITDA cannot be applied when the underlying profit metric is negative. And for companies that have just broken even, profits are far below long-term potential, making those multiples meaninglessly high. EV/Sales solves this because sales can never be negative.
The critical qualifier: EV/Sales suits only companies likely to turn profitable and sustain it. If a company is loss-making with no turnaround in sight, its “going concern” nature becomes doubtful — and such companies must be valued at liquidation value.
Asset-based multiples
Recall from earlier chapters: ROE = Net profit ÷ Equity (net-worth) and ROCE = EBIT ÷ Capital employed (debt + net-worth) — the returns on the book values of equity, and of equity plus debt, respectively.
Price-to-Book Value. While P/E and EV/EBIT(DA) measure what you invest to earn a unit of profit, P/B measures what you invest to gain ownership of the company’s assets:
P/B = Market capitalisation ÷ Balance sheet value of equity, or equivalently Price per share ÷ Book value per share
Where it works: P/B is preferred for the financial sector rather than sectors with tangible assets, because most financial companies’ assets are monetary, so book value closely reflects fair value. In capital-intensive firms, historical-cost accounting means balance-sheet values often don’t reflect fair value. And in services and technology firms, the most important assets — human capital and self-generated intellectual property — don’t appear on the balance sheet at all. Because accounting follows conservatism, book value is often used to derive a conservative value of equity even where it isn’t ideal.
Lower P/B is more attractive all else equal — but companies with higher ROE should command a premium, since equity is being employed more efficiently.
The workbook’s worked example: AFB Finance has total equity ₹9,900 lakh on 50 lakh shares → BVPS ₹198; at ₹200 market price, P/B = 1.01. LKH Finance has equity ₹8,000 lakh on 50 lakh shares → BVPS ₹160; at ₹175, P/B = 1.09. So AFB is less expensive despite the higher share price — a nice reminder that price per share tells you nothing on its own.
And a methodological caution worth carrying: compare a company’s multiple against the industry average, not one peer — but in fragmented industries with outliers, the mean gets pulled up while most firms sit near the median, so check both mean and median before concluding.
EV to Capital Employed. EV = Value of equity + Value of debt − cash and cash equivalents EV/Capital Employed = EV ÷ (Total equity + Total debt)
Used together with ROCE, this tells you the return on the capital you are actually investing. The workbook’s example is the most illuminating calculation in the chapter: net worth ₹1,00,000, debt ₹1,00,000, market cap ₹5,00,000, no cash, ROCE 45%. Capital employed = 2,00,000. EV = 5,00,000 + 1,00,000 = 6,00,000. EV/Capital Employed = 3. So although the business earns 45% on its capital employed, the investor paying 3× that capital earns only one-third of it — 15% (45% on 2,00,000 = 90,000, which is 15% on 6,00,000). And working backwards: an investor demanding a 20% minimum return would pay no more than 45/20 = 2.25× capital employed, i.e. ₹4,50,000. That’s the whole price-versus-value idea reduced to arithmetic.
Net Asset Value (NAV). NAV of equity is the market value of assets minus the value of liabilities — distinct from book value/net worth because it uses the market value of assets, not book value. It can be expressed in total or per share. Used for extremely asset-oriented businesses: real estate, shipping, aviation.
Other specialised metrics:
- Price/Embedded Value — specifically for life insurance. Embedded value is the present value of expected net future cash flows (probability-adjusted) from policies currently in force.
- Price/Adjusted Book Value — ABV is fair value of assets minus fair value of liabilities, and unlike book value it factors in off-balance-sheet items. Applied to NBFCs.
- EV/Capacity — when financial metrics don’t reflect potential value, as with start-ups or special situations, use operating metrics instead: a large steel plant currently out of operation can be valued on production capacity; an e-commerce start-up on number of users, number of transactions, or transaction value.
Trading multiples vs transaction multiples
Relative valuation is intuitive — we do it when buying an apartment by checking comparable flats in the locality. It’s quick and needs few assumptions, but it reflects the current market mood, which may be very optimistic or pessimistic — so it’s good practice to use maximum, minimum and average values rather than a single point.
The comparables come from two places: the stock market (trading multiples) or recent comparable deals (transaction multiples). The workbook’s judgment: transaction multiples are more relevant, because they represent an entity’s actual willingness to acquire the asset at that value, making them relatively more authentic than traded prices.
Sum-of-the-Parts (SOTP)
Many businesses operate as a cluster of businesses rather than one — ITC and L&T are the workbook’s examples. The best approach is to value each business separately and add them up. Each vertical is treated as an independent business, valued on earnings and assets as described above, then simply summed.
New-age businesses
On the valuations of e-commerce and tech companies — WhatsApp, Zomato, LinkedIn, Facebook — the workbook is refreshingly blunt: it’s difficult to put numbers together to arrive at the valuations at which those transactions happen, and it may be our own limitation in understanding the value proposition. The new-age vocabulary is eyeballs, page views, footfall, ARPU, number of users. But as Buffett would say, all of these must ultimately translate into profits for owners at some point. Without visibility of that, such valuations sustain only while there’s a storyline, people who believe it, and a next buyer — and collapse like a pack of cards without them, as happened in the dot-com boom of 2000–2001.
Is valuation objective?
It appears so, but it is a very subjective exercise: the inputs across all these methods are subjective, without generally accepted standards. Valuation is also not timeless — it can change dramatically when business circumstances change. The conclusion the workbook draws is worth memorising as written: there is no precise estimate of value, and complicated quantitative models do not mean the valuation is precise; they only create a false impression of preciseness.
Nine considerations to carry into every valuation
The chapter ends with a checklist that is pure exam material and genuinely good practice:
- If a business’s earning power is high, book value matters less; if earning power is low, book value becomes very important.
- Since a share is part-ownership, to value a share you must value the entire business.
- EV, not market capitalisation, is the true value of the firm for a private owner.
- P/E for a leveraged firm may be deceptive — look at debt levels.
- Look at consolidated numbers, not just standalone.
- Focus on ROE, not EPS — EPS does not account for retained earnings.
- Leverage improves ROE, but excessive leverage is risky.
- Differentiate ROCE from ROE — ROCE reflects the true return on capital; ROE can be manipulated by high leverage.
- ROCE and ROE should be closely knit — any wide variation should trigger investigation.
How this chapter is tested — with the case math worked
Twelve marks, heavily numerical, and paired with Chapter 8 as the make-or-break of the paper.
The standalone samples are quick: rising interest rates → bond prices fall; earnings yield on ₹195 price with ₹13 EPS → 13/195 = 6.67%; and the P/E formula is price ÷ EPS (note the distractors invert it — read carefully, because the reciprocal is earnings yield).
The case study is the real test, and its six questions form a complete drill. Working through the workbook’s own case (Company A: EPS 17.0 → 19.5, P/E 15.4x, EBITDA 4,754.6, debt 1,640.5, cash 169.0; Company B: EPS 26.8 → 32.2, P/E 18.2x, EBITDA 3,938.8, debt 1,626.8, cash 57.0):
Why is B’s P/E higher? Compute both growth rates: A grows EPS 17.0 → 19.5 ≈ 14.7%; B grows 26.8 → 32.2 ≈ 20.1%. Higher growth justifies the higher P/E. Note the distractors — a smaller base does not justify a premium, and high leverage certainly doesn’t.
Which is cheaper on PEG? A: 15.4 ÷ 14.7 ≈ 1.05x. B: 18.2 ÷ 20.1 ≈ 0.91x. B is cheaper — the same reversal as the A Ltd/B Ltd example earlier in the chapter.
Market cap of A: P/E × Net profit = 15.4 × 2,763.1 ≈ ₹42,600 lakh (equivalently, EPS 19.5 × P/E 15.4 × share count).
EV/EBITDA for B: EV = market cap + debt − cash = 36,000 + 1,626.8 − 57.0 = 37,569.8; ÷ EBITDA 3,938.8 ≈ 9.54x.
Fair price of B at a 20% premium to a 16x peer P/E: fair P/E = 16 × 1.2 = 19.2; × EPS 32.2 = ₹618.
Fair equity value of A at 8.5x EV/EBITDA: EV = 8.5 × 4,754.6 = 40,414.1; then equity = EV − debt + cash = 40,414.1 − 1,640.5 + 169.0 ≈ ₹38,943 lakh. Note the direction of that last step — going from EV to equity you subtract debt and add cash, the exact reverse of building EV from market cap. Getting that backwards is the single easiest way to lose this mark.
The formulas to have automatic: Gordon growth (P = D₁/(k−g)), CAPM (Ke = Rf + β(Rm − Rf)), WACC with the (1−tax) on debt only, FCFE and FCFF build-ups both ways, earnings yield and its P/E reciprocal, PEG, EV both directions (market cap + debt − cash, and back), P/B via BVPS, and EV/Capital Employed with the ROCE-dilution logic.
The conceptual traps: which discount rate pairs with which cash flow (FCFF↔WACC, FCFE↔cost of equity — mixing these is the classic error); EV/EBITDA for capital-intensive industries vs EV/EBIT elsewhere; EV/Sales only where profits are negative and a turnaround is likely, else liquidation value; P/B for financials, not for services/tech where the key assets are off the balance sheet; risk-neutral (probability-adjusted, risk-free rate, insurers) vs real-world (most likely cash flow, risk-adjusted rate); terminal growth capped at nominal GDP growth; transaction multiples more authentic than trading multiples; and the companion-variable discipline — a low multiple may be a bargain or a warning, and only the underlying fundamental tells you which.
My approach: this chapter cannot be passed by reading. I’m building one spreadsheet with a dummy two-company table exactly like the case above and computing every one of those six answers until each takes under a minute, plus a formula card for CAPM/WACC/Gordon/FCFF that I rewrite from memory each morning. Chapters 8 and 10 together are 24 marks of pure arithmetic — the highest-return practice in the whole syllabus.
Next up: Chapter 11 — Fundamental Analysis of Commodities. A change of pace after the two heavyweights. See you in the next note.
Note: These are my personal study notes as I prepare for the NISM-Series-XV Research Analyst exam. They are for learning purposes only and are not investment advice.