BUSINE VAL SS UATION AP ROACH S AND M T ODS P E EH
Overview of Valuation Approaches ,Methods & Procedures The Valuation methodology is organized into a hierarchy of three basic levels • Approaches • Methods • Procedures Valuation Approach -General course of action in which an indication of value is to be developed Valuation Method - a way an Approach can be implemented. Valuation Procedures- specific calculations, data used and other details involved in a method
VALUATION APPROACHES• Income Approach – valuing the business based on some form of economic income stream• Market Approach or Relative approach– valuation by reference to other transactions• Asset-Based Approach – valuation on the basis of assets and liabilities
VALUATION METHODSIncome Approach – Discounting method – Capitalizing methodMarket Approach – Guideline public company method (GPM) – Guideline merged and acquired company method (GMAM)Asset-Based Approach – Adjusted net asset value method – Excess earnings method
DCF methodDCF value = PV of CF + PV of the terminal period CFgenerally two phase DCF model is adopteddiscount rate is the cost of capital for the type ofinvestment and not the investorcapitalisation rate = discount rate - growth rateThe growth rate during the terminal period cannot exceedthe the growth rate of the economy
DCF method • NPV (Net Present value under free cash flow approach is called ‘firm value ‘ or ‘enterprise value’) • NPV (Net Present value under Equity cash flow approach called ‘equity value’) • Gordon Model or DDGM • Adjusted present value (APV) • Real option
DCF methodThe enterprise value of the company is calculated as under:Free cash flow discounted at WACC (weighted Average Cost Ofcapital) plus value of excess cash and marketable securities, crossholding and other non operating assets (like pension fund assets,joint venture investments etc)Step I Determine phase I (an initial time period over which youexpect the company to maintain a competitive advantage and it isgenerally 5 years and the range may be 3 to 10 years)Step II Estimate the free cash flows (FCF): amount of cash generatedby the business before allowing for financingStep III: Estimate the Horizontal value (HV) or Terminal value - whatwill be the worth of the business at the end of that initial period(called horizontal value or PV of phase II CF)
DCF methodHow to Calculate Horizontal value?It could be :• HV = earning of the last year of the forecast period x suitable multipleHV = Constant perpetuity or growing perpetuityStep IV Determine a suitable WACC (discount rate) for the investmentStep V Discount the FCF using the WACCStep VI Add the value of excess cash and marketable securities, cross holding and other non operating assets.Step VII In order to calculate the value of the equity of the company, deduct the current amount of debt from the enterprise value Step VI value is called the value of status quo (that is value under existing management
VCP is the value of control premium that is the difference between the value of an optimally managed firm and the value resulting from Status Quo Valuation:Control Premium (CP) = Value of an optimally managed firm – VSQ
VSP is the positive added-value from combining two firms andincludes diversification premium. Theoretically, synergypremium (SP) is synergy Premium (SP) = Value of thecombined firms -Value of the target firm -Value of theAcquiring Firm
DCF METHOD“TEN CIRCLES OF HELL by DAMODARANCurrent year numbers: “It’s amazing how wedded we are to that one-year, baseline number.”Cash flows. “You can’t stop forecasting cash flows until you’re willingto make an extraordinary assumption: that your cash flows are going togrow at a constant rate into perpetuity,” “It’s the tail that wags everyvaluation dog.”Taxes:“We double count some, add some, ignore some.” Growth. “We want all our businesses to grow, but ask the wrong people—the owners and managers—and you’ll get ‘30% growth rate for as far as the eye can see.” Don’t ever let the growth rate exceed the risk-free rate,
DCF METHOD“TEN CIRCLES OF HELL by DAMODARAN ,Discount rate. “I think we spend far too much time talking about cost of equity,cost of capital, cost of debt—and not enough on cash flows.” Analysts“outsource” so many of the elements of the calculation (to Ibbotson’s data,Bloomberg data, Duff & Phelps, etc.), “that it’s frightening.”Growth rate revisited. To grow a business, owners have to put money backinto the business, and that’s a cost of growth analysts may overlook. Instead,the focus should be on the quality of the business’ growth.Debt ratio revisited. “We spend a lot of time trying to get the discount rateright,” “But given your own assumptions about the company, you should expectthe discount rate to change [over time].” Instead, “the discussion should beabout the discount rates.”
DCF METHOD“TEN CIRCLES OF HELL by DAMODARANGarnishing valuations : “The practice of garnishing defeats the entire point of the ,valuation,” “It puts you back to…trying to get the number that you want and puts all ofour biases into play.”Per-share value. An issue primarily for public company valuations, which questions the“easy” practice of determining per-share value by dividing the company’s market valueby the number of shares—but often overlooks stock options, liquid/illiquid shares, etc.I-bankers inferno. The “darkest, deepest” layer of hell is reserved for those investmentbankers who have forgotten the “purpose of a valuation,” and in pricing an M&A deal,will often pick the wrong company (the target company instead of the acquirer) and thewrong discount rate (cost of debt instead of cost of equity) to arrive at the number (fees)they want
Determinants of the value of a business • History of stable growth and profits • Product Cycle point • Size Market share • Industry • Customer base -diversification • Growth potential-topline and bottom line trends • Competitive positioning • Product mix • Uniqueness • The value of similar companies • Strategy for continued growth and profitability • Timing
Steps for business ValuationStep I: Pre-engagement ProceduresStep II: Data GatheringStep III: Valuation AnalysisStep IV: Selection of Valuation MethodsStep V: Determining Final ValueStep VI: Report PreparationStep VII: Wrap-up Procedures
Concept of cash flowFree cash flows (FCF)• equal to its after tax cash flows from operations less incremental investments made in the firm’s operating assets• Cash flow to the firm as if there is no debt in the firmEquity cash flow• Cash flow to the equity shareholdersThe major differences in computation of cash flows are due to computation of taxes and treatment of debt.
Concept of cash flow The other difference may arise due to extra ordinary items or non operating items that affect ‘ PAT’ but not the operating Income.
Top down approach FCF FCFECash flow EBIT EBITDefinition Less: Tax on EBIT Less :Interest EBIT(1-T)=NOPAT Less: Tax on EBT Add: Depreciation Add: Depreciation Add/less: changes in net Add/less: changes in net operating working capital operating working capital Less: Repayment of principal Less: CAPEX amount of debt) ADD: proceeds of debt issue Less: CAPEXIRR Project IRR Equity IRRAppropriate WACC Cost of equitydiscountratePV of cash Project NPV Equity NPVflow
RELATIVE VALUATION (MULTIPLES) APPROACH• Relative valuation is more about market perception and mood• Under lying concept of the relative valuation is the law of one price-similar asset should command similar price• A multiple is the ratio of market price variable to a particular value driver of the firm• This approach is relevant as it uses observable factual evidence of “COMPS”
RELATIVE VALUATION (MULTIPLES) APPROACHKey Issues:Multiples• are easy to use but also easy to misuse• have very short shelf life (as compared to fundamentals)• use requires less time & efforts• Easier to justify and sell• closer to the market – more value if comparable firm is getting more value in rising market• RGC (Risk, Growth, Cash flow) may be ignored.• Accrual flow multiple dominates cash flow multiples
Types of Multiples • Equity based multiples • Entity or MVIC (Market Value of Invested Capital) multiples MVIC = no. of shares x MPS • Equity based multiples either give value of equity on market basis or book basis • MVIC based multiples either give value of firm on market basis or book basis • Must make adjustment for non-operating assets under MVIC method
HOW TO USE MULTIPLES IN VALUATIONStep I: selection of value relevant measure and valuedriversStep II: Identification of “COMPS”Step III: Select and calculate appropriate multiple –aggregationof multiple into single number through analysis of “COMPS” multipleStep IV: Apply to the companyStep V: Make final adjustments for non-operating assets,Contingent liabilities and convertibles.
Selection of value relevant measure• Equity multiple or entity multiple ?• Which value driver/ multiple to use?• Trailing multiple or forward looking multiple?• More number of multiples vs. less multiples- purpose relevant multiple vs. sanity check multiples
Selection of value relevant measure• Matching principle – numerator and denominator should have consistent definition• Capital structure – equity multiple is greatly affected by the capital structure than entity multiple• Difference in earning guidance and investment and payout policy• Stage of business life cycle• Empirical research supports forward looking multiples processing two years analysts forecast
Criteria for identification of comparable firm• Use industry classification system or at least list firm’s competitors SIC: Standard Industrial classification GICS: Global industry classification benchmark) Go up to 3 or 4 digits classification (more homogeneous) rather than 1 or 2 digits (broad industry group) Size and region Number of comparables- 4 to 8 ideal size( plus or minus 2
Criteria for selection of multiple Select comparable companies or transactions – how?•Management Style•Size•Product & Customer diversification•Technology•Key Financial trends•Strategic & operational strategies•Market positioning & maturity of operation•Geographical consideration•Trading volume of selected companies•Price volatility (σ)•Distribution of multiples – across the sector & market
Equity Multiples • P/E (Price Earning Ratio) • P/B (Price to Book Ratio) • Equity / Sales • Equity / Cash flow • Equity / PAT • Equity / Book value of share
MVIC ( Market value of invested capital)• MVIC / Sales• MVIC / EBITDA• MVIC / EBIT• MVIC / Book value of invested capital• MVIC/TA
Equity multiple Price Earning Ratio – most commonly used multiples • Make sure definition is consistent & uniform PER = MPS / EPS • Variant of PER Current PER = Current MPS / Current EPS Some analyst may use average price over last 6m or a year • Trailing PER = Current MPS / EPS based on last 4 quarters. [or, LTM: Last twelve months] • Forward PER = Current MPS / expected EPS during next F/Y • EPS may further be based on fully diluted basis or primary basis • EPS may include or exclude extraordinary items
Equity multiple - PER• For Growth Company forward PER will consistently give low value than trailing PER• Bullish valuer use forward PER to conclude that stock is undervalued.• Bearish valuer will consider Current PER to justify that Stock is overvalued.• Full Impact of dilution may not occur during next year leading to lower EPS.• While using industry PER be careful about outliers• MLF (money loosing firm) creates a bias in selection• Equity value is calculated based on existing outstanding shares but EPS is on fully diluted basis.
Equity multiple – PEG (Price Earning growth) PEG = PER / expected growth in EPS • One mistake analyst will make to consider growth in operating income rather than EPS • Growth should be consistent with PER calculation • Never use forward PER for peg as it amounts to double counting of growth • Lower the PEG better the stock • If PER is high without growth prospect, PEG will be high – risky firm • PEG does not consider risk taken in growth and sustainability of growth.
Equity multiple P/B ratio = market value of equity / book value of equity • Book value is computed from the Financial Statement • Price of book ratio near to 4 is highly priced stock [mean P/B ratio of all listed firm in USA during 2006 was 2.4] Price to Sales ratio (Revenue multiple) = market value of equity Revenue • The larger the revenue multiple better it is. • Generally there is no sectoral Revenue multiple.
MVIC multiple vs Equity multiple • MVIC multiple look at market value of operating assets of the firm (and not only for equity invested). • MVIC multiple is not affected by Finance leverage. • If firms under comparison are differing in their financial leverage, put more reliance on MVIC multiple.
ASSET BASED APPROACH determining a value indication of a business, business ownership interest, orsecurity using one or more methods based on the value of the assets net of liabilitiesMethod 1: Adjusted Net Value MethodMethod2: Excess Earnings Method
ASSET BASED APPROACHAdjusted Net Value Method• Identify all assets & liabilities (recorded and unrecorded tangible and intangible assets, liabilities & contingents)• Determine which assets and liabilities on the balance sheet require valuation• Value the items identified• Construct a value-based balance sheet using the adjusted values• Value of assets = adjusted value of assets - outside liabilities
ASSET BASED APPROACHExcess Earnings Method Steps:• Estimate a normalized level of operating earnings, the operating tangible asset value, and a reasonable rate of return to support the tangible assets• Multiply the reasonable rate of return by the value of tangible assets to arrive at the reasonable money return on tangible assets• Determine excess earnings by subtracting the return on tangible assets from normalized earnings- if it is negative then there is no intangible value
ASSET BASED APPROACHExcess Earnings Method Steps (continued):• Determine the capitalization rate appropriate for the excess earnings• Determine the value of intangible assets by dividing the capitalization rate into the excess earnings• Add the value of tangible assets to the value of intangible assets
ASSET BASED APPROACHApply this approach generally where• Company is going in liquidation• Asset intensive companies -Significant value of assets for going concern• For control valuation• Real estate companies• Investment companies• Finance companies• Startup stage company• Distressed companies