2. 2
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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.
?? ?
?
3. 3
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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.
?? ?
?
4. 4
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AGENDA
Topic Slide no.
Background 6
Valuation methods 13
Cost based 16
Book value 18
Goodwill 24
Intangible assets 28
Replacement 31
Liquidation 32
Income based 33
Earnings capitalisation 35
DCF 36
Limitations of DCF 43
Market based 52
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AGENDA
Topic Slide no.
What value depends on 63
Valuation process 67
Special situations
Multi business 75
M & A 84
Cyclic companies 91
Companies in distress 94
Cross border transactions 97
Privatisation 102
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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?
8. 8
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What is value
Cost vs. Market Value
Historical vs. Replacement
Differs depending on need of
person doing valuation – buyer,
seller, employee, banker,
insurance company
9. 9
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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
18. 18
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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
19. 19
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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?
20. 20
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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
21. 21
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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?
22. 22
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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
23. 23
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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…
25. 25
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Valuation of goodwill
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
26. 26
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Valuation of goodwill
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
27. 27
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Valuation of goodwill
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
28. 28
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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?
29. 29
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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
30. 30
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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
35. 35
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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
36. 36
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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?
Year Net CF 15%
disc.
Rs. ‘000
1 -10,000 1
2 1,000 0.8696
3 3,000 0.7561
4 5,000 0.6575
5 6,500 0.5718
37. 37
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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?
Year Net CF 15%
disc.
NPV
Rs. ‘000 Rs. ‘000
1 -10,000 1 -10,000
2 1,000 0.8696 870
3 3,000 0.7561 2,268
4 5,000 0.6575 3,288
5 6,500 0.5718 3,717
5,500 142
39. 39
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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
40. 40
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Discounted cash flow
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
41. 41
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Discounted cash flow
∑
=
= +
=
nt
t
t
t
r
CF
Value
1 )1(
• 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
44. 44
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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
45. 45
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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
46. 46
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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
48. 48
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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
49. 49
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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
50. 50
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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.
53. 53
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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
59. 59
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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
64. 64
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Valuation depends on
Management team
Historical performance
Future projections
Project, product, USP
Industry scenario
Country scenario
Market, opportunity, growth
expected, barriers to competition
65. 65
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Valuation depends on
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)
69. 69
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Process of valuation
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
70. 70
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Process of valuation
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?
75. 75
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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
76. 76
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Multi business models
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)
77. 77
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Multi business models
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
78. 78
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Multi business models
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
79. 79
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Multi business models
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’
80. 80
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Multi business models
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
81. 81
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Multi business models
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
82. 82
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Multi business models
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)
83. 83
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Multi business models
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
84. 84
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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
91. 91
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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
92. 92
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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
93. 93
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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)
95. 95
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Companies in distress
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
96. 96
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Companies in distress
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
97. 97
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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
98. 98
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Cross border 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
100. 100
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Cross border transactions
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
101. 101
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Cross border transactions
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
102. 102
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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
This is so in the case of companies, just as in the following examples:
land plus house can be less than land separately
existing house – if 1st floor is constructed the value immediately increases more than the cost of construction
For total class of investors
Many companies look very troubled in recession
Land value high, one could consider market value of land or rental from land, whichever may be applicable
Perceptions of Risks in the above lead to different valuations. Each element above can again be split into various factors. ie teams entrepreneurship quality and experience in running businesses in the past, professionalism of team, attention to detail
Mgmt team must have clearcut idea – who handles what, one CEO, group dynamics. Also in VC if one team member is known, it is +ve, unlike in banking where this is percieved as favouritsm., bec confidence level goes up.
Bet on team first - very people oriented ie directors, advisors and key team
Financial risk depends on each of these factors
Requirements of clauses of tie-in, statutory environment, shareholding patterns required to be fair for protection of entrepreneur interest, dilution of VC interest on later stages of funding and conversions etc. relevant for exit options will affect valuation ie at each stage valuation depends on return to the investor which is linked to the exit possibility.
Eg. one entrepreneur wanted to list for IPO, but could not because of change in SEBI requirements. Immediately his valuation fell. Angels invested in his company at high premiums in 1st round, anticipating sale at some point. However they later become reluctant to finance 2nd round because no exit was in sight. Entrepreneur was stuck at this time without being able to give value to investors now as compared to few months before this change… and many such stories abound….
Value depends on amounts of funds required. Many persons find in India today that if they require say 25 to 50 lacs, it is difficult to find financiers. In such a case the valuation will be low. If they require larger amounts as there are many VCs, it may be easier to get funding.
Many entrepreneurs prefer to get small amounts from family etc. so that they can go to formal VCs at a later point in time and get better value, ie can give out smaller % of their company for larger amounts.
Valuation varies in each of these
Methods built up over a certain period of time
As per frame work
laid down and understood by students of finance and those dealing with this subject.
Valuation not to be irrational
ie return to investor must be perceived to lead to profit in future
All dotcoms cannot be judged on same parameters and same business models. As we have seen dotcoms can come in different forms and have different ways of adding value. Valuation models to break down elements of models
Let us see some of these elements in the next few slides
Who, when, why – being valued
Varies from time to time, today could be Rs. 1000 cr, tomorrow a fraction of this
Of quoted example of Sabeer Bhatia who is reported to have said that he learnt negotiating skills accompanying mother at shopping in Bangalore ( ie form of best bargain, fair value)
Ideally the sum of the whole should be greater than the sum of its parts