Valuation

Valuation Rs. Anjana Vivek www.venturebean.com [email_address]

FOREWORD
How does one value a company? While at a broad level one may be able to understand why a company may be worth a certain amount to an investor or a buyer, it is not always possible to understand why someone is willing to pay a certain amount for a business.
? ? ?

FOREWORD
A business worth a significant amount at a certain point in time may suddenly lose much of its value a very short while later.
This is what happened in many companies commonly referred to as ‘dot-com companies,’ which were valued at amounts which may seem absurd now…. in hindsight.
? ? ?

AGENDA 52 Market based 43 Limitations of DCF 36 DCF 35 Earnings capitalisation 33 Income based 32 Liquidation 31 Replacement 28 Intangible assets 24 Goodwill 18 Book value 16 Cost based 13 Valuation methods 6 Background Slide no. Topic

AGENDA 102 Privatisation 97 Cross border transactions 94 Companies in distress 91 Cyclic companies 84 M & A 75 Multi business Special situations 67 Valuation process 63 What value depends on Slide no. Topic

BACKGROUND - FAQs
Why do values of companies change from time to time?
Does value depend on whether one wants to sell a company, to buy a minority stake or to buy the entire company?
Will a strategic investor value a company differently from a financial investor?
How can a company which is continually losing money have any value?

VALUATION PROCESS
Review and selection of the methods of valuation
Understanding of issues which impact valuation
Special situations and their impact on valuation

What is value
Cost vs. Market Value
Historical vs. Replacement
Differs depending on need of person doing valuation – buyer, seller, employee, banker, insurance company

Value to user
Valued because of expected return on investment over some period of time; i.e. valued because of the future expectation
Return may be in cash or in kind

Complex nature of valuation
Value A + Value B can be
greater
or
less than
Value (A+B)

Why Value
When do you think a company is to be valued?

Why Value
To
Purchase
Sell
Transact
Take decisions
Report

VALUATION METHODS

Valuation methods
These can be broadly classified into:
Cost based
Income based
Market based

Valuation methods
Different experts have different classifications of the various methods of valuation
Within these methods, there are sub-methods
Sometimes the methods overlap

1. COST BASED METHODS

Cost based methods
Book value
Replacement value
Liquidation value

Book value method
Historical cost valuation
All assets are taken at historical book value
Value of goodwill* is added to this above figure to arrive at the valuation
*We will see how goodwill is valued in later slides

Book value method
Historical cost valuation
All assets are taken at historical book value
Value of goodwill is added to this above figure to arrive at the valuation
Do you think there would be any difficulties in this?

Book value method
Current cost valuation
All assets are taken at current value and summed to arrive at value
This includes tangible assets, intangible assets, investments, stock, receivables
VALUE = ASSETS - LIABILITIES

Book value method
Current cost valuation
All assets are taken at current value and summed to arrive at value
This includes tangible assets, intangible assets, investments, stock, receivables
What do you think could be difficulties in this method?

Book value method
Current cost valuation: Difficulties
Technology valuation – whether off or on balance sheet
Tangible assets – valuation of fixed assets in use may not be a straightforward or easy exercise
Could be subject to measurement error

Book value method
Current cost valuation: More difficulties
The company is not a simple sum of stand alone elements in the balance sheet
Organisation capital is difficult to capture in a number – this includes
Employees
Customer relationships
Industry standing and network capital
Etc…

Valuation of goodwill
Based on capital employed and expected profits vs. actual profits
Based on number of years of super profits expected
May be discounted at suitable rate

Normal capitalisation method
Normal capital required to get actual return less actual capital employed
Super profit method
Excess of actual profit over normal profit multiplied by number of years super profits are expected to continue
Annuity method
Discounted super profit at a suitable rate

COMPANY A
Capital employed: Rs. 45 cr
Normal rate of return: 12 %
Future maintainable profit: Rs. 5.5 cr
What would be the goodwill under the normal capitalization method?
SOLUTION: (change font colour to see this)
= (5.5/.12) – 45 = Rs. 0.83 cr

COMPANY B
Capital employed: Rs. 50 cr
Normal rate of return: 15 %
Future maintainable profit: Rs. 8 cr
Super profit can be maintained for:3 years
What would be the goodwill under the super profit method?
SOLUTION: (change font colour to see this)
= [8 – (50*.15) ] * 3 = Rs.1.50 cr

Valuation of IA
The value of the IA is from
Economic benefit provided
Specific to business or usage
Has different aspects
Accounting value
Economic value
Technical value
Can you think of examples of these different values?

Valuation of IA
Depends on objective and can vary widely depending on purpose
For accounting purposes – to show in financial statements
For acquisition/merger/investment
For management to understand value of company for decision making

IA value in transactions
Often value paid in M&A deals is more than market value/book value. This could be:
Partly due to over bidding due to strategic reason (existing or perceived) and
Partly due to IA of company, not captured in balance sheet

Replacement value method
Cost of replacing existing business is taken as the value of the business

Liquidation value method
Value if company is not a going concern
Based on net assets or piecemeal value of net assets

INCOME BASED METHODS

Income Based methods
Earnings capitalisation method or profit earning capacity value method
Discounted cash flow method (DCF)

Earnings capitalisation method
This method is also known as the Profit earnings capacity value (PECV)
Company’s value is determined by capitalising its earnings at a rate considered suitable
Assumption is that the future earnings potential of the company is the underlying value driver of the business
Suitable for fairly established business having predictable revenue and cost models

Discounted cash flow method
Creame Corner wants to acquire Samosa Specials for Rs. 10 million. The net cash flows are in the table below. Creame Corner wants to apply a discount rate of 15%. Should it buy Samosa Specials?
0.5718 6,500 5 0.6575 5,000 4 0.7561 3,000 3 0.8696 1,000 2 1 -10,000 1 Rs. ‘000 15% disc. Net CF Year

Discounted cash flow method
NPV is positive hence based on this method, the answer is YES, the acquisition should be made!
Can you think of three deficiencies in this valuation method?
142 5,500 3,717 0.5718 6,500 5 3,288 0.6575 5,000 4 2,268 0.7561 3,000 3 870 0.8696 1,000 2 -10,000 1 -10,000 1 Rs. ‘000 Rs. ‘000 NPV 15% disc. Net CF Year

Applicability of DCF method
Cash flow to equity
Discount rate reflects cost of equity
Cash flow to firm
Discount rate reflects weighted average cost of capital

Discounted cash flow
Cash flow to equity
Valuation of equity stake in business
Based on expected cash flows
Net of all outflows, including tax, interest and principal payments, reinvestment needs

Cash flow to firm
Value of firm for all claim holders, includes equity investors and lenders
Net of tax but prior to debt payments
Measures free cash flow to firm before all financing costs

CF is cash flow
t is the year and
r the discount rate
i.e. the cash flow for each year from year 1 to year n (which is the time
period under consideration) is discounted to arrive at the present value
of future cash flows from year 1 to n

Applicability
Discounted cash flow is based on expected cash flow and discount rates
Sometimes it is difficult to get a reliable estimate for the future and the valuation model may need modification

Limitations
Companies in difficulty
Negative earnings
May expect to lose money for some time in future
Possibility of bankruptcy
May have to consider cash flows after they turn negative or use alternate means

Limitations
Companies with cyclic business
May move with economy & rise during boom & fall in recession
Cash flow may get smoothed over time
Analyst has to carefully study company with a view on the general economic trends. The bias of the analyst regarding the economic scenario may find its way into the valuation model

Limitations
Unutilised assets of business
Cash flow reflects assets utilised by company
Unutilised and underutilised assets may not get reflected in the valuation model
This may be overcome by adding value of unutilised assets to cash flow. The value again may be on assumption of asset utilisation or market value or a combination of these

Limitations
Companies with patents or product options
Unutilised product options may not produce cash flow in near future, but may be valuable
This may be overcome by adding value of unutilised product using option pricing model or estimating possible cash flow or some similar method

Limitations
Companies in process of restructuring
May be selling or acquiring assets
May be restructuring capital or changing ownership structure
Difficult to understand impact on cash flow

Limitations
Companies in process of restructuring
Firm will be more risky, how can this be captured?
Historical data will not be of much help
Analysis should carefully try to consider impact of such change

Limitations
Companies in process of M&A
Estimation of synergy benefit in terms of cash flow may be difficult
Additional capex may be calculated based on inadequate information or limited data
Difficult to capture effect of change in management directly in cash flow
Analyst should try to study impact of M&A with due care

Limitations
Companies in process of M&A
Historically, many M&As have not done as well as expected. Many times this has been attributed to valuation being too high. To minimise this risk of over valuation, a proper due diligence review (DDR) exercise is to be done, with one of the mandates for this being careful review of the value drivers and the business proposition.

Limitations
Unlisted companies
Difficult to estimate risk
Historical information may not be indicative of future, particularly in early stage, growth phases
Market information on similar companies can be difficult to obtain

MARKET BASED METHOD

Market based method
Also known as relative method
Assumption is that other firms in industry are comparable to firm being valued
Standard parameters used like earnings, profit, book value
Adjustments made for variances from standard firms, these can be negative or positive

Exercise in Valuation

Value estimated

Exercise in Valuation

Value estimated ? Since multiples differ, this cannot be used as a dependable guide for valuation

Relative Valuation
Using fundamentals
Valuation related to fundamentals of business being valued
Using comparables
Valuation is estimated by comparing business with a comparable fit

Relative Valuation
Using fundamentals for multiples to be estimated for valuation
Relates multiples to fundamentals of business being valued, eg earnings, profits
Similar to cash flow model, same information is required
Shows relationships between multiples and firm characteristics

Relative Valuation
Using Comparables for estimation of firm value
Review of comparable firms to estimate value
Definition of comparable can be difficult
May range from simple to complex analysis

Applicability
Simple and easy to use
Useful when data of comparable firms and assets are available

Limitation
Easy to misuse
Selection of comparable can be subjective
Errors in comparable firms get factored into valuation model

VALUATION: What it depends on

Valuation depends on
Management team
Historical performance
Future projections
Project, product, USP
Industry scenario
Country scenario
Market, opportunity, growth expected, barriers to competition

Nature of transaction
Whether 1st round or later round
Whether family and friends or other parties
Amount of money required
Stage of company - early stage, mezzanine stage (pre-IPO), later stage (IPO)

Strategic requirements and need for transaction
Demand / supply position
Flavour of the season
Initial ballpark valuation can also be a deal issue

VALUATION: Process

Process of valuation
Consider
Net assets tangible and intangible
Financial data
Historical information
Company info
Industry info
Economic environment

Include elements of cash, costs, revenues, markets
Plan long term not short haul
Use more than one model
Discount for risks, assign probabilities
Arrive at range
A valuation range is preferable to a single number

Finally after arriving at the value range
raise some fundamental questions
Does the value reflect the past performance and the expected future?
Does the value reflect the USP as compared to competition?
Does the value reflect the quality of the management?

The last mile…
Does the valuation reflect the picture you have of the business?
Would you be willing to pay this price?

Valuation: for investment
Valuation is perception in the eye of the beholder
It is subject to negotiation
Investor Value Company Value Function of time

Valuation: in M&A
Value of combined business is expected to be more than value of the individual companies
Value (A+B) Value A + Value B

APPLICATION OF
VALUATION MODELS
In special cases

Multi business models
The entire business is valued as a sum of the parts
Valuation depends on successful management of different units
Strategic decisions usually occur at each business unit level
To understand the company one needs to first understand the opportunities and threats faced by each business unit

Valuation of company that is based on valuation of individual business units provides deeper insight
Valuation of individual business units also helps understand whether the company is more valuable as a whole or in parts and to understand where the value is (eg. in some units or in the company as a whole)

Particularly useful in restructuring and reworking business and financial strategy of the business going ahead
Helps understand and get a better picture of costs of the corporate office and understand allocation of these costs and whether these can be reduced

Identifying business units can be complex
Cash flows projection can be complex and interdependent on different units
Allocation of corporate office costs and other company costs/benefits may be difficult

A business unit is identified as one which can be split off as a stand alone unit or sold to another enterprise
Units are to be logically separable
They should not have depend production/sales/distribution etc.
Some joint products may fall under one unit, if there is interdependency which calls for this
If there is limited interdependency, this may be viewed by considering transfer pricing and whether transactions could be considered ‘arms length’

Allocation of corporate costs including some or all of these:
Salary and other costs of key management
Board costs
Corporate administration costs
Costs of listing as a public company
Advertising and marketing costs

Allocation methods are to be carefully thought through and could be a combination of different methods for different costs, including
Based on time spent (time sheets)
Advertising based on revenue

Benefits are also to be incorporated, including
Saving on operational costs
Information/communications
Tax benefits / shields (ie one loss producing unit would provide a shield to another profit making one – important when one is considering a split up / hive off of some units)
Intangible benefits – can these be quantified? (Eg key person in management team / Board)

Difficulties and concerns
Partial holdings in units (taken as a percentage of ownership of business unit value)
Double counting may occur
Allocation may pose difficulties
Interdependency may not be easy to separate
Intangibles cannot be easily quantified
Transfer pricing to be viewed in the regulatory context

Mergers/Acquisitions
These have become very important as companies try to grow inorganically or network to exploit possible synergies
Most senior executives may be involved in such transactions
Directly or indirectly
In the buy side or target side

Rationale for the proposed transaction is to be understood
Synergy
Revenues
Costs
Intangibles
Control/ dominance in market
Under valuation perceived (LBOs/LBIs)

Studies show that generally acquired company shareholders gain
Reasons for failure
Poor post acquisition management
Over payment for target

Research has suggested that the following factors have resulted in positive deals
Bigger value creation overall
Lower premiums paid
Better run by acquirers

Overpayment could be because of a combination of these factors:
Market potential - overoptimistic appraisal
Synergy – overestimated
Due diligence – inadequate
Bidding – excessive

Synergy
Operational (vertical and horizontal M&A eg backward integration, captive customer)
Functional (Production, sales)
Benefits (tax, control etc.) and impact on cash flow to be quantified (eg. increased sales, reduced wages) keeping timing in mind

LBOs/LBIs
Initially high leverage
May be followed by rapid reduction in debt
This impacts business risk which will change

Cyclic companies
Fluctuation in earnings over different periods in time
One approach taken is that if done correctly, DCF evens out fluctuations /volatility in the long term because all value is reduced to a single period
However position of current year in cycle, needs to be factored in as it is considered as base year

Cyclic companies
Growth rates in different years need to be adjusted based on expected cycles
There may be difficulty in estimating cycles accurately
If future differs from past, this would impact forecasts and therefore impact valuation

Cyclic companies
It is important to have different possible scenarios and arrive at a range of values should be arrived
This is useful as managers can implement decisions based on the valuation depending on the stage of the cycle the company is in (eg. for buyback, issue of shares, raising of debt funds)

Companies in distress
May have one or all these problems
Negative cash flow
Unable to pay back debt
Liquidity crunch

Valuing the company based on expectation of turnaround
Assume the company will be healthy soon and look at future based on a healthier past
Analyse based on future expected transaction in which cash flow is identifiable

Liquidation value
Sum of parts based on individual identification of units
Consider different alternate scenarios of units in different combinations
Consider all assets tangible and intangible
Cap at possible realisable value

Cross border transactions
There are special issues in such cases, including
Foreign exchange fluctuations
Difference in regulations (statutory, accounting)
Estimating cost of capital
Country risks
Inter country transactions

Analyse past performance
Translate Fx into host country financials, based on accounting standards
Include any tax implication (eg subsidiary may pay dividend tax only if this is paid out)
Arrive at FCF and convert to domestic currency

Consider impact of restrictions on transfer of currency
In place of FCF, multiples may also be used

View impact of accounting regulations on financials
Provisions (pension)
Goodwill (amortised or against equity)
Revaluation of assets
Deferred taxes
Fx translations
Non operating assets
Tax

Cost of capital
Market risk premium difficult to estimate, sometimes proxies are used
Risks in changing regulations
Political risks
Illiquid capital markets
Restrictions on cash flows

Privatisation
Listed companies have the following which may lead to increased costs
Increase in information to be provided per listing requirements
Separation of ownership and management (good/bad?)
Focus on stock prices at the cost of fundamental growth, in many cases

Privatisation
Implication of privatisation
Reduced access to finance
Reduced visibility of company (impact on brand)
Reduced requirement for compliance/governance
Impacts to be factored in for valuation, to the extent possible

Valuation

by Anjana Vivek on Sep 04, 2009

Accessibility

Categories

Tags

Upload Details

Usage Rights

1 Embed 14

Statistics

Valuation — Presentation Transcript