Valuation of companies using financial statements

Abstract

The objective of the study is to examine whether the market to book ratios as predicted by the valuation method based on the concept of value drivers is reflected or not in reality in Indian stock market. Four companies were shortlisted for analysis viz. Reliance Industries Limited, Bajaj Auto Limited, Infosys Technologies Limited, and Associated Cement Companies (ACC). Their financial statements for the past five years obtained from CMIE -PROWESS database were analyses based on two frameworks. The Value driver framework deals with the actual model to estimate equity value based on the valve driver concept and the Framework for Fundamental Information Analysis identifies the set of useful financial variables that can be used to support security valuation. The value driver framework says that three value drivers profitability, reinvestment rate and advantage horizon are the key to the financial, strategic and investment decisions of the firm. These two frameworks were combined a sensitivity analysis of predicted Market - Book Ratios to profitability and advantage horizon performed. The balance sheets and income statements of the last five years 1993 - 1997 ) of the four companies have been analyses to arrive at an estimate of profitability and advantage horizon. The reinvestment rate was the average retention ration of the companies. The profitability of ACC and Reliance Industries is observed to be less than the cost of equity unlike Infosys and Reliance. From the sensitivity analysis, it appears that the Market - Book values estimated by the model tends to underestimate the market price. The reasons could be that the model suffers from the drawback of not being based on cash flows and losing on accurate prediction of future. Also, estimation of advantage horizon is extremely difficult and the results of the sensitivity analysis shows that the Book - Market values are more sensitive to the advantage horizon than to the profitability. It is quite likely that the analysis has estimated advantage horizon more conservatively than the market estimate.