I used the model below to value Dr. Reddy's.
Single Stage Growth
To use the multistage discounted cash flow methodology we need two growth numbers – 1) Short term growth (G), and, 2) Long term growth (g). For long term growth we usually use the nominal GDP growth rate as the perpetual growth rate. The short term growth rate (G) for the immediate 5 years will be based on the Single Stage Growth Model. The steps to calculate the Single Stage growth are listed below.
1. Retrieve the historical financial data as far back as possible. The data is retrieved from the Wharton’s Research database since the model has been designed based on the structure of the data.
2. The model uses the key value drivers to calculate the growth rate. In our model we retrieve data until 2009 (Mar, 2010) to calculate the values drivers, namely, Invested Capital Turnover (A), EBITDA Margin (M), Depreciation rate (D), and Marginal Tax Rate (T). We also calculate the WACC based on current 2011 data.
3 Value Drivers:
(Invested Capital = Total Assets Invested – Total Liabilities advanced)
Invested Capital Turnover – Regressing historical salest+1 against Invested Capitalt
Margin – Regressing Salest against EBITDAt
Depreciation Rate (D) – Regressing Depreciationt+1 against Invested Capitalt
Marginal Tax Rate (T) – Regressing pre taxt income against Total Income Taxt
4. Calculation of WACC:
Cost of Debt – S&P does have the credit rating for Dr. Reddy’s. But based on the ratings given to pharmaceutical majors like Pfizer (rated AA), we assume a rating of A with a 10 yr cost of debt of 3.9% (retrieved from the data for corporate bond rates).
Cost of Equity – We use the Fama French 3 factor model to derive the cost of equity
5. The model will use these numbers along with the unknown growth rate (the variable here) to arrive at the ratios, namely, EV/Invested Capital (K), EV/EBITDA, and EV/Sales. The objective of the model is to calibrate the three ratios to the current ratios by adjusting the growth rate. In our case the model will give us the growth of Dr. Reddy’s from going forward.
6. The formulae are given below:
Price/Book (EV/K) = (ROIC – G)/ (WACC – G)
EV/EBITDA = (EV/K)/ (A*M)
EV/Sales = (EV/K)/ A
ROIC = (A*M – D)*(1 – T)
7. The model uses this single stage growth rate to forecast the sales growth for the next five years. The single stage growth rate gives us a perspective on how the sales would grow over the next five to ten years if the company continued performing the way it has in the past. But it is understood that markets and economy are both very dynamic and therefore often we adjust the growth rate (given by the model) to account for future performance.
Multi Stage Growth
The model calculates the FCF for the immediate 5 yrs and the terminal value to get the fair share value. The steps are listed below:
1. FCF = NOPLAT – Change in Invested Capital
NOPLAT = EBIT – Adjusted Taxes
EBIT = EBITDA – Depreciation
EBITDA =Fixed Cost + M*Sales
Depreciation = D*Invested Capitalt-1
Adjusted Taxes = T*EBIT
2. The Terminal value is calculated using the following logic:
Net Investment in the 5th year*(EV/Invested Capital)
Net Investment = Invested Capital (yr 5) – Invested Capital (yr 4)
EV/Invested Capital = ((1-T)*(M*A – D) – g)/ (WACC – g)
I hope the above listed steps would help you in valuing companies. I have used this model and I like it because the value drivers are identified by regressing historical data. Therefore, by looking at the R square value you can be sure how strong your model is. Please note that the more the data you feed into the model the more stronger the model becomes.
