Basic valuation methods
The key objective of this report is to evaluate and determine whether the market has valued TATA STEEL Limited correctly or not. This report demonstrates the application of three basic valuation methods namely the Net Asset Value, Price Earnings Multiples and Discounted Cash Flow to determine future value of TATA STEEL Ltd on a 10 year planning horizon from the perspective of potential investors and shareholders. Evidence based projections has been done on the value drivers such as revenue growth, working capital, Capital expenditure etc. Before undertaking the firm valuation it is essential to know the past performance of TATA STEEL Ltd with respect to value delivered to its shareholders. Therefore, a brief analysis is done to identify how successful TATA STEEL Ltd has been in delivering value to its shareholders over the last five years.
Additionally, an analysis of the Change in the Value of equity (share price movement) for the previous 12 months has been done. A final value is recommended based on the valuations arrived from different valuation techniques and a critical evaluation of the advantages /disadvantages of each of the methods have been done.
The analysis has been done from an investor's perspective and has revealed that TATA STEEL Ltd (w.r.t its listing on the Bombay Stock exchange) has been leading the Steel industry in India in terms of Return on Shareholder funds. TATA STEEL Ltd's market share performance has been commendable even under harsh economic conditions and analyst reports have dwelled on TATA STEEL Ltd's resilience and advised investors to hold on to their shares as the company performance has a potential upward trend.
Introduction and Company profile
The concept of determining and measuring an exact value of a company is a crucial part of financial management in its approach to enhance value. Financial managers assess the value of the company mostly during mergers and acquisitions. When determining the value of a company every investor values it differently depending upon different factors e.g. resources available, costs and future plans. The value of the company primarily depends on the market efficiency. If there is an active and efficient market in the company's shares, the value of the company would be a much reliable one. The value of the company changes with different parameters and even calculated guesswork makes it difficult to determine the exact value of the company (Pike & Neale 2009).
Tata Steel is the world's 6th largest steel company with an existing annual crude steel production capacity of 30 Million Tons Per Annum (MTPA). Established in 1907, it is the first integrated steel plant in Asia and is now the world`s second most geographically diversified steel producer and a Fortune 500 Company (Annual report, 2007-08).
TATA Steel has had a huge increase in Turnover (415.04 % YoY), Increase in operating profit (115.18% YoY) and Profit after tax (PAT - 195.66% YoY) mainly due to the acquisition of Corus Steel, UK.
Shareholder Value Analysis
Total Shareholder Returns (TSR)
Total Shareholder Returns represents the change in capital value of a listed company over a period of time, plus dividends, expressed as a percentage of the opening value.
TATA Steel's TSR % has been declining for the past four years which is a potential worry to investors (Figure.1). However, TATA Steel Ltd revealed that 2008 has been a good year with dividends hitting 26.19 % more than previous year and that it's TSR led the industry by nearly 200% in comparison to the BSE's performance (Annual Report, 2007/08). Furthermore, shareholders' funds have also increased to 133.71% w.r.t to previous year, which is a sign of increase in investment in TATA Steel's shares (Annual Report, 2007/2008). The major reason for the growth in Total Shareholder funds has been the acquisition of Corus Steel, UK which catapulted Tata Steel's to the sixth largest steel maker in the world.
Except for a dip in share price in the second half of 2006-07 the share prices of TATA Steel Ltd have been outperforming the BSE Index and Steel sector, indicating a strong management performance and shareholders trust in the future of the company(Appendix - B). TATA Steel has also added value by the Corus Steel's acquisition in the year 2007-08. Over the past five years TATA Steel has delivered an overall gain of 50% in the Total Shareholder returns and a consistent yield on dividend year on year. TSR has been very good for TATA Steel over past five years making the portfolio stronger for potential investors (Annual Report, 2007/08).
Looking at SVA(Shareholder Value Analysis), TATA Steel has followed value drivers like sales growth, margin focus, acquisitions, dividends, tax rate structure to use all the business, investment and financing strategies(Pike & Neale, 2009). Hence it is fair to conclude that TATA Steel Limited has added value to shareholders through its dividend and reinvestment policies and performed well in its Steel Industry sector and BSE 30 Index. As in Appendix - B, the share price movement for TATA steel Ltd, over the last 5 years, shows that there has been an overall capital gain of 413.06%.Economic Value Added (EVA) - Stern Stewart Approach
EVA measures economic return achieved by a company from the capital invested. It is a useful tool in assessing how TATA Steel Ltd delivered value to its investors through the performance of its value drivers. Table 2 shows that TATA Steel has destroyed value through EVA in the FY 2007-08 and is mainly because of the acquisition of Corus Steel, UK.
EVA is a measure of performance but is a backward looking tool (Pike & Neale, 2009). EVA relies heavily on the cost of capital. Though EVA is a simple and powerful tool for assessing performance but since it is based on book value, rather than market values it is inadequate to use it alone but can be supplemented using other techniques (Chandra , P , 2008). Fig.2 shows the trend of EVA by TATA Steel over last 5 years based on values from Appendix -C.Dividend Policy
Dividend Payout ratio
Dividend payout ratio (DPR) measures what percent of the company's earnings have been given to shareholders as cash dividends. A low payout ratio indicates that company has chosen to reinvest most of the profits back into the business. Mature companies pay higher dividends than the companies in the phase of growth (Pike & Neale, 2006). Table 3 shows that TATA Steel Ltd's dividend payout ratio has been over the consistent in the last five years and is now slightly on the mode of increment.
The dividend credit tax rate for TATA Steel is 24.64% and accordingly the Dividend Yield to Shareholders has been a healthy figure consistently. An average dividend yield of 4.26 % is good and does indicate that market reckons that the company has impressive prospects and isn't overly worried about the company's dividend payment. This means that market expects high growth for the company (Pike & Neale, 2009).
TATA Steel Ltd has shown steady growth in its dividend policy adding value to the shareholders. Table-3 illustrates the steady increase in dividend paid over the last five years. As it can be noticed in Table.4, EPS has equivalent growth to DPS, which is progressing at a steady rate. This is due to the fact that TATA steel is also retaining profits for the future growth and paying dividends at the same time hence adding value to the shareholders.
Share Price Movement - Change in the Value of equity - Last 12 months
Under Semi-strong form of Efficient Market Hypothesis, the stock market reacts rationally not only to past performances but also to publicly available information determining the true value of the company (Pike & Neale 2009). Over time, market has expressed their trust in TATA Steel to consolidate, grow at the same time and increase sales which determines a very positive future. Fig 3 represents the graphical movement in share price of TATA Steel Ltd for the past 12 months.
As if Fig.3 ,the shares showed a consistent decrease in price value with the plummeting of aggregate steel demand in the world markets triggered by recession effects in most of the developed economies. The future growth/expansion plans have been retarded due to the weakening economy thereby adversely affecting share prices.
The share price has dropped from being at Rs.748 per share on the 1st of Feb, 2008 to Rs.181 on the 2nd of Feb2009 thereby dropping by nearly 310% percent over a year and adversely down trended due to recession (Refer to Fig.3)
In the last 12 months, the demand for Steel is almost down 40 percent compared to the entire 2007. Steelmakers have struggled with sales as a global credit crisis has hit demand from major steel-consuming industries such as automotives, consumer goods and construction. Global steel production tumbled 24 percent in the last quarter of 2008.Tata Steel said net profit from Indian operations, which accounts for about a fifth of its total output, fell 56.4 percent to 4.66 billion rupees ($95.5 million) for its fiscal third quarter, from 10.7 billion rupees reported a year earlier."Profits are lower mainly because of auto industry volumes not picking as expected the company was hurt by the high cost of coal. It imports 40 percent of its requirements (Mehra .P, 2009.)
Towards the end of January 2009, India's main stock index rose 2.8 percent as rebounding world markets calmed risk aversion concerns. The 30-share BSE index closed up 2.81 percent, or 253.39 points, Tata Steel (TISC.BO) rose 2.6 percent to 176.85 rupees as investors shrugged off a 56 percent fall in quarterly profit and focused on a recent rally in steel stocks globally (Shah. M, 2009).
Comparing against BSE Small Cap and Steel Sector, (Figure 3) - in the initial stages, the success of Corus acquisition had its positive effect on the share price. However in the second half there was decrease in revenue due to plummeting of steel prices. In the Longer run, the EMH favored TATA Steel thereby with a share price leading the domestic market (Yahoo Finance, 2009).Evaluation of Equity
The concept of value is at the heart of financial management, valuation is by no means an exact science. Inability to make precise accurate valuations complicates the task of equity evaluation. With a well established market in the asset concerned and if the asset is fairly homogenous, valuation is relatively simple. So long as the market is reasonably efficient, the market price can be trusted as a fair assessment of value (Pike & Neale, 2009).
Additionally, value of a whole company (i.e. the value of its entire stock of assets) may differ from the value of the shareholders stake in the case of TATA Steel Ltd which is a partly debt capital financed company (Pike & Neale, 2009).
The three basic evaluation methods used are "NAV", "P/E multiples" and "Discounted Cash Flow (DCF)" methods.
Net Asset Value (Owner's Equity)
The method includes the calculation of the equity value of a firm by netting the liabilities against the assets. The method differentiates between company or enterprise value and the value of the owners' stake is clarified based on scrutiny of company's accounts (Chandra .P, 2008).
NAV based on the balance sheet figures (as on 31st March 2008) for TATA Steel Ltd is 7977.47 Crores as in Table.5. But, the actual value of the assets is expected to be different. Although Appendix D, takes into account such differences and calculates NAV after adjustments but it's not a realizable assumption to make. The book values are often historical and far from the market values in case of property, plant and equipment. NAV method of valuation does not take into view the earning power of the assets of the company. The accuracy of the book value approach depends on how well the net book values of the assets reflect their fair market values (Chandra, P, 2008).
However, the market value of equity (As on 31/03/2008) is 8429.50 Crores w.r.t a trading share price of Rs.693.15 (Google finance, 2008).
The implied value of share by NAV turns out to be Rs.655.98 which is less compared to the share price of Rs.693.15. The use of NAV approach makes the company undervalued.
Price - Earnings ratio (Multiples) - (P/E ratio)
P: E ratio is a measure of the market's confidence in a particular company or industry (Pike & Neale, 2008). By this we can estimate a share's value as the amount investor or acquirer would be willing to pay for each unit of earnings. It indicates how the market rates the company's prospects. Using P/E ratio, an investor can make an offer as a multiple of the earnings of the target company (Chandra.P, 2008).
For a company with a higher P/E ratio, than the market or industry average, it means that the market is expecting big things over the next few months or years. (Investopedia, 2009).
It's difficult to determine whether a particular P/E (Table. 6) is high or low without taking into account two main factors:
Company growth rates- How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future?
Industry- To compare companies such as SAIL and Jindal Steel within the same steel industry in the Indian Market.
Value of equity derived from P: E is higher than the NAV value. TATA steel's current PE Ratio for (FY -2007-08) is 10.32 (Fig.4). Its main competitors in the India, SAIL and Jindal Steel Ltd have a P/E ratio of 10.12 and 27.19 respectively. TATA steel's P/E ratio is competitive with the peer group and the steel industry which is 5.08 (Damodaran, 2009).
Discounted Cash Flow (DCF) Approach
Valuing a firm using the DCF approach is conceptually identical to valuing a capital project using the present value method (Chandra P, 2008). Value of growing companies depends not simply on the earning power of their existing assets, but also on their growth potential; in other words the NPV of the cash flows from all future non-replacement investment opportunities (Pike & Neale , 2009) .
However, the differences are (Chandra P, 2008):
- While a capital project is deemed to have a finite life, a firm is considered as an entity with an indefinite life.
- A Capital project is typically valued as a one-off investment. A firm however is viewed as a growing entity and for valuing a firm, it is important to consider all investments in fixed assets and net working capital that are expected to be made over a period of time to sustain the growth of firm.
For proper valuation of the company, in the concept of cash flow, an assessment of the total ongoing investment needs, anticipated revenue and operating cash flows are to be done. The inflow remaining net of investment outlays is referred to as free cash flow (Pike & Neale, 2009).
FCF is the post tax cash flow generated from the operations of the firm after providing for investments in fixed investment and net working capital for the required operations of the firm (Chandra P, 2008).
The World's crude steel production has declined in FY 2007-08 by 1.1% on YoY basis. During the period FY 2001-2008, the world crude steel production has grown at a Compounded Annual Growth Rate (CAGR) of 7.9%. With the global economic meltdown in FY 2008, global crude steel production in each month, post the month of August, has registered a negative growth on YoY basis. India's finished steel production has increased from 35.4 mn tonnes in FY 03 to 52.8 mn tonnes in FY 08, registering a CAGR of 8.3%. During the same period, finished steel consumption has grown at an incremental CAGR of 11.9%. Demand for Indian Steel is expected to slow down but to grow at a CAGR of 8.0% in FY09-11 (Bharatbook, 2009).Operating Profit Margin - EBIT
Tata Steel and Corus Steel are being run with same scale of performance improvement initiatives for improvements in operating efficiencies and cost reduction. The long term plan is to reduce cost and consistently improve operating margins as a % of sales revenue (Annual Report, 2007/08).
The company's operating cost margin is going down. The cost of operations in emerging economies like India and South East Asia is very less as compared to other parts in the world (Annual report, 2007/08). The operating costs have been significantly brought down to $US 250 making TATA Steel Ltd as the lowest cost steel make in the world and has initiatives to sustain low cost production(Annual Report 2007/08). Therefore it's reasonable to assume the pattern of growth in operating profits as shown in the Table. 9 above.Reinvestments
Capital expenditure on fixed assets has been made on the basis of sales revenue growth pattern. The sales revenue is expected to be quite consistent with the projected CAGR of 8.5 % - Indian Steel Industry for the span FY 2009-12 in alignment with the demand for steel (Bharatbook, 2009).Hence with respect to the revenue growth, the capital expenditure has been projected to grow in the below mentioned pattern as in Table.10 :
Tata Steel Ltd has proposed three Greenfield steel projects in the states of Jharkhand, Orissa and Chhattisgarh in India with additional capacity of 23 MTPA and a Greenfield project in Vietnam by 2011(Angel Research, 2009).Working Capital
Working capital refers to the cash a business requires for day-to-day operation. TATA Steel Ltd's working capital has increased as the sales grew over the last 4 years. Hence, to support the growth forecasted, the working capital must increase correspondingly. Hence it is reasonable to assume that working capital will increase and decrease at the same rate as sales revenue growth. The trend is as shown below in Table.11:Depreciation/Amortization
Depreciation/Amortization for TATA Steel has been reasonably assumed to maintain at a constant rate of 4.36% derived from the past figures as shown below in Table. 12:Taxation and Interest
Tax rate is assumed to remain at around 30% based on the past year trend which averages pretty much the same. However, a reasonable assumption has been done backed with the data from the Government of India that all domestic companies (Based out of India) will have to pay a Corporate Sales tax of (35+ 2.5 %) surcharge (GOI, 2009). All international revenues would also be taxable at the same percentage for the 10 year planning horizon. Hence, it is assumed that from 2013 onwards, the 37.5% would be applicable.Cost of Equity (Gordon Growth and CAPM Models)
Weighted Average Cost of Capital
Terminal value of firm
Free Cash flow and Net Present Value
Free cash flow (FCF) is the actual amount of cash generated from operations (inflow) minus investment outflow (Chandra .P, 2008)
For forecasting purpose the capital structure of TATA Steel Ltd is assumed to remain the same. Hence, the Cost of Equity of 20.31% as in (Appendix - F) used to calculate the WACC of 8% as in Appendix - G) is used as the discount factor to calculate the Net Present Value (NPV).
The cost of equity (Ke) calculated using the CAPM Model is being used basically for because the CAPM model considers the Market risk factor and the effects of dividend policy of the company which is included within it. However, the Gordon Growth model only considers the effect of dividend payout policy and critically misses out the Risk Factor.
The table as in Appendix - I shows thee free cash flows and net present value for TATA Steel Ltd on a 10 year Planning Horizon.
The Net Present Value for TATA steel @the base year (2008) is 60744.88 croresEnterprise value and Value of Equity through the DCF Approach
Enterprise Value = 60744.88 crores + 114145.466 crores = 174890.36 crores
Equity value is the enterprise value after the net debt is paid out.
Therefore, Equity Value = Enterprise Value - Debt = 174890.36 crores - 49352.15 croresValue of Equity @ DCF Approach = INR 125,538.21 crores
The chief value drivers affecting the value of equity for TATA Steel are Operating margin (EBITDA) and Cost of capital (%).Operating Margin+ Depreciation (EBITDA)
TATA Steel's terminal value at the end of FY 2018 has been based on the (EV/EBITDA) ratio which is 3.5 consistent over the past 4 years (Angel Research, 2009).Also, the EBIDTA value is a highly sensitive one for TATA Steel since its dependent directly on Prices of Steel worldwide. Hence, sensitivity of Earnings to steel prices is high for Corus and consequently TATA steel compared to integrated companies in the world. (Angel Research, 2009).
Hence a Slight variation in EV/EBITDA ratio would lead to a significant change in the enterprise value as illustrated below.
If EV/EBITDA ratio is 4, the Value of Equity is Rs.141, 844.69 Crores which is a 12.99% increase in the Value of Equity as per a ratio of 3 (Refer Appendix - J).
If EV/EBITDA ratio is 3, the Value of Equity is Rs. 109,231.70 Crores which is a 14.92% decrease in the Value of Equity as per a ratio of 3 (Refer Appendix - J)
Hence with the reduction in the Operating Margin (%), the Enterprise value undergoes a change by a significant value in an inversely proportional manner.Weighted Average Cost of Capital (WACC)
The WACC includes the Risk of the Business as well as the Cost of Debt and Cost of Equity. The variation in WACC would definitely have a major impact on the Net present Value of the firm as shown in (Appendix - K)
With a WACC of 6 %, The NPV is 64684.13 Crores and consequently the value of Equity is 133,477.46 crores. This has increased by 6.32 % with respect to 125,538.21 crores.
On the other hand, with a WACC of 10%, The NPV is 53907.89 Crores and consequently the value of Equity is 118,701.21 Crores. This has decreased by 5.76% with respect to 125,538.21 crores.
Hence the Risk of business and (Cost of funds - Debt/equity) summed up as the Cost of capital has a significant impact on the value of equity.
Valuation based on different methods has produced different results as summarized below,
Net Asset Value (NAV) = Rs. 7977.47 Crores = 1.085 Billion GBP
P/E Multiple = Rs. 48370.15 Crores = 6.578 Billion GBP
Discounted Cash Flow Method = Rs. 125,538.21 Crores = 17.073 Billion GBP /p>
Conversion : - 1 Crore = 10 million / Currency : 1 rupee = 0.0136 GBP (www.xe.com/ucc)
The asset values have calculated based on the Historical Cost convention method used by balance sheets in valuing the company's assets .It not been adjusted while valuating TATA Steel Ltd using NAV method. Due to lack of information on current evaluation of assets, no assumptions were made in calculating the current value of assets. NAV is unlikely to be a reliable guide to valuation since it does not take into account the earning potential of the assets. However, it's a reference point for valuation and assures that Rs.7977.47 Crores is the least minimum that TATA Steel Ltd should anticipate to realise if it considers breaking up the company assuming no change in the assets over the previous year.
Using the sector P/E multiple, TATA steel is valued at Rs. 48370.15 Crores. Also, TATA Steel's P/E of 10.32 is competitively high compared to its closely comparable competitors. Though the PE ratio is very high as compared to the business services sector but it's not realistic to compare it with the whole business services sector as that contains companies in different service areas. PER does not consider the long term benefits and is totally based on Efficient Market Hypothesis which can be many times unpredictable and undefined. PE Ratio is based on the accounting profit while a firm value is determined by its expected cash generation (Barber.P, 2008/09)
Using the DCF method, the company is valued at Rs. 125,538.21 Crores. DCF valuation is based on various assumptions made about the economic growth and company's earning potential. Looking at the values calculated by different methods it can be argued that cash flows can be considered reliable, however projections can be too high or too low. DCF calculates future cash flows and discounts it back at a rate which considers the risk of the investment included within the cost of capital and hence measures overall intrinsic value of the asset. Also, it's the cash flows that add value to the shareholders wealth in terms of returns.
Having considered different models, value of TATA steel Ltd is 125,538.21 Crores or 17.073 billion GBP using the DCF approach. This clearly implies that current market price of Rs.176.30 per share does not truly reflect TATA Steel Ltd's earning potential. TATA Steel still has a high growth potential with increasing revenues and margins supported by plans to expand worldwide in terms of Greenfield capacity expansion and through acquisitions (Business Line, 2009).
Appendix - A: - Set of formulae used
- Total Shareholder return (TSR) = ((Share price at end of period - Share price at begin of period) +Dividends)) / (Share price at the begin of period)
- Earnings per share (EPS) = (Net Income - Dividends on preferred stocks))/No. of Equity Shares)
- Price -Earnings ratio (P/E ratio) = (Market price per share / Earning per share)
- Return on Capital Employed (ROCE) = (Operating Profit)*100/ (Share Capital + Reserves + Non-current liabilities)
- Gross Operating profit margin = (Gross Operating profit/Sales Revenue)*100
- Net Operating profit ratio (Return on Sales) = (Net Operating profit/Sales Revenue)*100
- Net Debt: Secured and Unsecured Loans -Cash and bank balances - Current investments
- Equity : Total Shareholder returns - Miscellaneous Expenses
The value of the firm could be found out either by summing up all the book values of investor claims or the assets of the firm may be totaled and from this the total non-investor claims (like accounts payable and provisions) may be deducted. However the market values differ from the book values because of (Chandra .P, 2008):
- The Book value of an asset is based on its historical cost less depreciation whereas doesn't consider the factor of "inflation" which influences the market value.
- Some assets become obsolete and worthless even before they are fully depreciated and
- Organizational capital, a very valuable asset is not included in the balance sheet.
Tata Steel is however better placed to weather an industry downturn as it is the most integrated company in the world with 100% captive iron ore and 70% coking coal. However, Corus in the UK which contributes around 75% of consolidated Revenues and 50% of consolidated EBIDTA is a concern amidst the falling steel prices for Tata Steel consolidated. However, falling steel prices is a concern now for Corus as it is a non-integrated steel company unlike parent Tata Steel, India (Angel Research, 2009).
With reference to Q3, 2009 results, after witnessing a steep spike in prices since January 2008, steel prices have collapsed by more than 50% in the last couple of months owing to the sharp fall in Spot raw material prices and uncertainty over the demand for steel on the back of adverse macro-economic factors globally. This has affected the firm's revenues (Angel Research, 2009).
Considering the Industry growth and TATA steel's past growth rate and future plans (Angel Research, 2009), it is reasonable to assume growth rate for TATA Steel to be 10% until 2011(because the company has few projects running till that year). This assumed rate is taken with a view that though the company is bound to increase its market share in the UK and Euro zone and nearly half of the revenues of the company would be generated in UK by Corus. The company has slight demand for steel based on projects until 2011(for Olympics in 2012. After 2011 company's revenue would boost with the buoyant demand for steel worldwide. A reasonable assumption is taken that the company would grow by 12% from 2011; but from 2016 the growth rate predicted to be 9% since the business cycle is such that there could be a recession again in 8-9 years time from now (Begg/Ward, 2008). The revenue growth percentage in the year 2008(Base year) was exorbitant due to the consolidation of the financial statements of Corus and Tata Steel, India following the former's acquisition by the latter.Appendix - I: Discounted cash flow projection and NPV
Free cash flow (FCF) = [(Revenues - Operating Costs) - (Interest payments) - (taxes) +(Depreciation) - (Capital Expenditure) and plus/minus (Changes in Working Capital)]
Enterprise Value = (PV of cash flow during forecast period) + (PV of the terminal value)
Net Debt = (Secured and Unsecured Loans - Cash and bank balance - Current investments)
Equity = Shareholders' funds - Miscellaneous expenses
Equity Value = Enterprise Value - Net Debt
ote: For TATA Steel Ltd, Unsecured Loans doesn't include any short term loans and hence net value is the Long term debt itself
TATA Steel Ltd is growing rapidly along with the acquisition of Corus Steel, UK and is in a dominant and a competitive position in the market. But it operates in a competitive market and hence the sustainability of the current growth for a longer term becomes a challenge. Moreover, due to the UK economy showing signs of slow down, the demand for steel has been stifled thereby leading to curtail in the revenue growth. But, the company is experiencing substantial growth in emerging markets (Nair S, 2007). Therefore, a reasonable assumption is made that TATA Steel has growth drivers to sustain the current growth for ten years.The forecast period for the Future cash flow is 10 years i.e. from 2009-2018 with year 2008 as the base year (Year-0).(As in the below drawn table)
The analysis has been prepared using the data available in the annual report and financial statement of TATA Steel for the years 2003-04 to 2007-08.
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