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Basics of valuation 03 12 10 by natarajan


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Basics of valuation by natarajan

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Basics of valuation 03 12 10 by natarajan

  1. 1. Basics of valuation 3 rd December 2010 R. Natarajan Chief Operating Officer Helion Advisors
  2. 2. Agenda <ul><li>Misconceptions about valuation </li></ul><ul><li>Fair Value </li></ul><ul><li>Fair value estimation </li></ul><ul><ul><li>Quoted Investments </li></ul></ul><ul><ul><li>Unquoted Investments </li></ul></ul><ul><ul><ul><li>Price of recent investment </li></ul></ul></ul><ul><ul><ul><li>Earnings multiple </li></ul></ul></ul><ul><ul><ul><li>Net Assets </li></ul></ul></ul><ul><ul><ul><li>Discounted Cash flows </li></ul></ul></ul><ul><ul><ul><li>Industry valuation benchmarks </li></ul></ul></ul><ul><li>SFAS 157 </li></ul><ul><li>Valuation at different stages </li></ul><ul><li>Regulatory implications </li></ul><ul><ul><li>Startup </li></ul></ul><ul><ul><li>Mid-stage </li></ul></ul><ul><ul><li>Growth </li></ul></ul><ul><li>Valuation </li></ul><ul><ul><li>Linear growth and Non linear growth </li></ul></ul><ul><li>Convertibles is another negotiation tool </li></ul><ul><li>Practical perceptions </li></ul><ul><li>Alignment of interest </li></ul><ul><li>Legal terms makes valuation complicated – Entrepreneurs don’t understand </li></ul><ul><li>Methods of valuation </li></ul>
  3. 3. <ul><li>&quot; One hundred thousand lemmings cannot be wrong&quot; </li></ul><ul><li> Graffiti </li></ul>
  4. 4. What is valuation?
  5. 5. Its all about perception Rs 1500 Rs 15,000 Rs 50,000 Rs 150,000 Rs 350,000
  6. 6. A philosophical basis for Valuation <ul><li>Many investors believe that the pursuit of 'true value ' based upon financial fundamentals is a fruitless one in markets where prices often seem to have little to do with value </li></ul><ul><li>There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers, and not by anything as prosaic as cash flows or earnings </li></ul><ul><li>Perceptions matter , but they cannot be all the matter. </li></ul><ul><li>Asset prices cannot be justified by merely using the “bigger fool” theory </li></ul>
  7. 7. Misconceptions about valuation <ul><li>Myth 1: A valuation is an objective search for “true” value </li></ul><ul><ul><li>Truth 1.1: All valuations are biased. The only questions are how much and in which direction </li></ul></ul><ul><ul><li>Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid </li></ul></ul><ul><li>Myth 2.: A good valuation provides a precise estimate of value </li></ul><ul><ul><li>Truth 2.1: There are no precise valuations </li></ul></ul><ul><ul><li>Truth 2.2: The payoff to valuation is greatest when valuation is least precise </li></ul></ul><ul><li>Myth 3: . The more quantitative a model, the better the valuation </li></ul><ul><ul><li>Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. </li></ul></ul><ul><ul><li>Truth 3.2: Simpler valuation models do much better than complex ones </li></ul></ul>
  8. 8. Fair value <ul><li>“ Valuation is nothing else than arriving at fair value for transacting parties” </li></ul><ul><li>“ Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between at the measurement date” </li></ul><ul><ul><li>Independent </li></ul></ul><ul><ul><li>Knowledgeable about the asset/liability </li></ul></ul><ul><ul><li>Able </li></ul></ul><ul><ul><li>Willing to transact </li></ul></ul>
  9. 9. What? <ul><li>Business Valuation </li></ul><ul><ul><li>Acquisition </li></ul></ul><ul><ul><li>Assessment of merger swap ratio </li></ul></ul><ul><ul><li>Valuation of business segments </li></ul></ul><ul><ul><li>Restructuring </li></ul></ul><ul><ul><li>Share purchase/ investment/ fund raising </li></ul></ul><ul><li>Valuation of Intangibles </li></ul><ul><ul><li>Brand or trade names </li></ul></ul><ul><ul><li>Customer contracts and relationships </li></ul></ul><ul><ul><li>Non compete agreements </li></ul></ul><ul><ul><li>Software and technology </li></ul></ul><ul><ul><li>Intellectual property </li></ul></ul><ul><ul><li>Human resources </li></ul></ul>
  10. 10. Know what we are valuing <ul><li>Enterprise value (EV) – the market/ fair value of economic assets </li></ul><ul><li>Equity value – the market/ fair value of the shareholders’ equity, i.e. the market/ fair value of the Enterprise value, once the debt has been reimbursed </li></ul><ul><li>In some circumstances individual tangible (e.g. capital requirement) and/ or intangible (e.g. trademarks, parents, contracts) assets are independently valued </li></ul><ul><li>Certain liabilities may also be required to be valued </li></ul>
  11. 11. Fair value estimation <ul><li>Determine EV of Investee Company using the appropriate valuation methodologies </li></ul><ul><li>Adjust EV for surplus assets, excess/ unrecorded liabilities and other relevant factors </li></ul><ul><li>Make adjustments for any financial instrument ranking ahead of the highest ranking instrument of the Fund in a liquidation scenario that may dilute the Fund’s Investment to derive the Gross Adjusted EV </li></ul><ul><li>Apply an appropriate Marketability Discount to the Gross adjusted EV to derive Net Adjusted EV which is apportioned between the company’s relevant financial instruments according to their ranking </li></ul><ul><li>Allocate the amounts derived according to the Fund’s holding in each financial instrument, representing their FV </li></ul>
  12. 12. Quoted investments <ul><li>Estimating value of investments quoted on active stock markets </li></ul><ul><li>At their bid prices on the reporting date </li></ul><ul><li>When bid price is not most representative the most representative point estimate in the bid/ ask spread can be used </li></ul><ul><li>Discount should not be applied to prices quoted on active markets unless there is some legal enforceable restriction which would impact the value realized at the reporting date </li></ul><ul><li>The valuer may consider an option pricing model to value the impact of any restriction on realization </li></ul>
  13. 13. Unquoted investments <ul><li>Estimating the Fair value of Unquoted investments </li></ul><ul><ul><li>Price of recent investment </li></ul></ul><ul><ul><li>Earnings multiple </li></ul></ul><ul><ul><li>Net Assets </li></ul></ul><ul><ul><li>Discounted Cash flows </li></ul></ul><ul><ul><li>Industry valuation benchmarks </li></ul></ul><ul><li>Valuation methods for each investment should be selected separately based on its appropriateness to that particular investment </li></ul><ul><li>Preferred methods to derive FV would be those methods that are entirely based on observable market data rather than based on assumptions </li></ul><ul><li>Where more than one method is appropriate for a specific investment, a combination of methods can be applied or value based on one particular method can be cross checked with values based on other methodologies </li></ul>
  14. 14. Price of recent investment <ul><li>When the investment has been made recently, its cost provides a good indicator of its FV </li></ul><ul><li>In case of recent investment by other investors, price of investment can be taken as the FV </li></ul><ul><li>Also suitable for Start ups, seed stage situations – where there are no current assets, short term future earnings or positive cash flows </li></ul><ul><li>Appropriate for all private equity investments, but only for a limited period post investments in the investee company </li></ul><ul><li>The length of period for which PRI would remain appropriate will depend appropriate will depend on market conditions internal or external environment post investment till the reporting date </li></ul><ul><li>The valuer attempts to assess whether changes or events have occurred subsequent to the date of investment impacting the FV </li></ul>
  15. 15. Multiples method <ul><li>Preferred method of valuation </li></ul><ul><li>Appropriate for an investment in an established business with identifiable stream of maintainable earnings </li></ul><ul><li>Multiple method based on earnings can be used for valuing businesses with positive earnings – P/E ratio, EV/ EBIT and EV/ EBITDA </li></ul><ul><li>However for businesses in development stage and prior to positive earnings being generated, revenue multiple can be used as a basis for valuation </li></ul><ul><li>Similar transactions </li></ul><ul><ul><li>Recent transactions involving the sale of similar companies are sometimes used as a frame of reference to derive a reasonable multiple </li></ul></ul><ul><ul><li>Not very popular due to lack of reliable pricing information for the transactions, lack of reported earnings of private companies </li></ul></ul>
  16. 16. Net Asset Value Method <ul><li>Business whose value derives mainly from the underlying fair value of its assets rather than its earnings, such as property holding companies and investment businesses (including Fund of Funds) </li></ul><ul><li>In the context of private equity – for valuing investments in loss making companies and companies making only marginal level of profits </li></ul>
  17. 17. Discounted cash flow <ul><li>DCF methodology uses the present value of future free cash flows of the underlying business of the investee company by using a appropriate discount factor to derive the FV of the investee company </li></ul><ul><li>In PW context DCF methodology being flexible, can be applied in situations where other methodologies are incapable of addressing. E.g. cases where business is going though a period of great change, turnaround, strategic repositioning or is loss making or it is in its start up stage </li></ul><ul><li>As DCF involves high level of subjectivity, DCF valuations are generally useful as a crosscheck for values estimated under market based methodologies </li></ul>
  18. 18. Industry Valuation Benchmark <ul><li>Industry specific benchmarks are used in specific industries such as certain information technology and service sectors where long term contracts is a key feature </li></ul><ul><li>This method assumes that investors are willing to pay for turnover or market share and the normal profitability of business of similar companies in the industry does not vary much </li></ul><ul><li>Valuation benchmarks includes industry norms such as </li></ul><ul><ul><li>‘ Price per subscriber’ – Cable and telecommunication industry </li></ul></ul><ul><ul><li>‘ Price per bed’ – Nursing homer operators </li></ul></ul><ul><li>This method is used to derive FV only in limited situations and can be generally used as a sense check for values derived using other methods </li></ul>
  19. 19. Valuation guidelines and principles <ul><li>SFAS 157 </li></ul><ul><li>International Private Equity and Venture Capital Valuation guidelines (IPEVC) </li></ul><ul><li>Private Equity Industry Guidelines Group (PEIGG) </li></ul><ul><li>“ It is not requirement of accounting principles that these guidelines are followed. However compliance with these accounting principles can be achieved by following the guidelines” </li></ul>
  20. 20. SFAS 157… Preference of approach depends upon relevant circumstances!! Valuation techniques Market approach - Uses prices and information generated by market transactions involving comparable assets/ liabilities Income approach - Converts future amounts to a single present discounted amount Cost approach - Amount currently required to replace service capacity of asset
  21. 21. SFAS 157 Levels of inputs Level 1: Observable market prices Level 2:Observable prices other than quoted prices Level 3: Unobservable inputs Quoted prices for similar assets and liabilities in active markets Quoted prices for similar assets and liabilities in inactive markets Observable inputs other than Quoted prices Inputs derived from / that can be corroborated by observable market data Entity’s reporting data Unobservable interest rates in a specified currency (related to foreign currency swaps)
  22. 22. Enough of theory and books let us move to some reality check
  23. 23. Valuation at different stages of business Start up Mid Stage Growth Team Team Performance Potential Performance Potential Potential
  24. 24. Valuation at different stages of business Linear Growth Non Linear Growth
  25. 25. Alignment of interest <ul><li>Rachet valuation Vs Fixed valuation </li></ul><ul><li>Promoter stake in the company </li></ul><ul><li>Skin in the game ?? </li></ul><ul><li>Exits—alignment of interest between promoter and Investor </li></ul><ul><li>ESOP, Salary issues, </li></ul>
  26. 26. “ Convertibles a win-win situation”
  27. 27. “ $50M valuation offered by investor can be expensive than $30M asked by entrepreneur” “ Understanding the technicalities and other conditions of valuations is equally important”
  28. 28. Regulatory implications <ul><ul><li>RBI guidelines – Change from CCI pricing to DCF </li></ul></ul><ul><ul><li>Foreign investor cant buy lesser than Fair market Valuation </li></ul></ul><ul><ul><li>Foreign investor cant sell higher than Fair marker Valuation </li></ul></ul><ul><ul><li>Pricing of the capital instruments that the Indian companies can issue under the FEMA regulations, should be “… decided/determined upfront at the time of issue of such instruments” - Issues related to valuation mismatch? </li></ul></ul><ul><li>Secondary purchase/ sale between non residents is all full of ambiguity around withholding taxes </li></ul>
  29. 29. Helion Ventures … The Journey So Far India Focused <ul><li>Twin opportunity </li></ul><ul><ul><li>Growing domestic market </li></ul></ul><ul><ul><li>Global </li></ul></ul><ul><ul><li>outsourcing </li></ul></ul>Multi-stage Venture Investment range from $2 - 10M Dual focus themes <ul><li>Indian consumer-services businesses </li></ul><ul><li>Technology-powered businesses </li></ul>+ * Started in June 2006 with $140M fund and raised another fund of $208M in February 2008 Active Capital
  30. 30. Thank You