Valuation Of Business
FOREWORD
How does one value a Business? Why does some one pay a higher amount for a particular business. A business worth a significant amount at a certain point in time may suddenly lose much of its value in a very short while. eg. Dot-com companies
Value
Value like beauty lies in the eyes of the beholder Price is what you pay, Value is what you get Warren Buffet
Why Value
To Buy Sell Transact Take decisions
VALUATION PROCESS
Review and selection of the methods of valuation Understanding of issues which impact valuation Special situations and their impact on valuation
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)
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Basic Principles in Business Valuation
Value of a Business
Expected Level of Economic Benefits Expected Growth of such Benefits
Risk Involved in Receiving the Benefits (discount rate)
Value is Based on Prospects
Past Performance as Surrogate for Future
Examine the companys operational, investment, and financial decision making
Prospects
Value Metrics
Value is a function of facts known and forecast made
The manner in which the business has operated is often considered a proxy of the future
Reading the companys financial statements
Accuracy, sustainability, and predictability of reported financial results
Composition of returns on equity
Capacity for continued investment
Steps in Valuation
Two Way Process Data Collection Data Analysis Estimations & Validations Value using various Methods Applying Premiums/Discounts Applying sanity checks
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Computing value
Cost vs. Market Value
Historical vs. Replacement Differs depending on need of person doing valuation buyer, seller, employee, banker
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Valuation: What does it depend on
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Valuation depends on .
Management team Historical performance Future projections Project, product, USP Country/ Industry scenario Market, opportunity, growth expected, barriers to competition
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Valuation depends on
Nature of transaction Amount of money required Stage of company - early stage, mezzanine stage (pre-IPO), later stage (IPO) Strategic requirements and need for transaction Flavour of the season
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VALUATION METHODS
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Valuation methods
Different experts have different classifications of the various methods of valuation Within these methods, there are submethods Sometimes the methods overlap
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Valuation methods
These can be broadly classified into:
Cost ( Asset) based Income based Market based (Relative)
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COST BASED METHODS
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Cost based methods
Book value
Historical Cost Current Cost
Replacement value Liquidiation Value
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Book value method
Historical cost valuation All assets are taken at historical book value Value of goodwill to be added to arrive at the valuation
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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
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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
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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
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Replacement value method
Cost of replacing existing business is taken as the value of the business
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Liquidation value method
Value if company is not a going concern Based on net assets or piecemeal value of net assets
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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
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Valuation of goodwill
Normal capitalisation method
Normal capital required to get actual return less actual capital employed Excess of actual profit over normal profit multiplied by number of years super profits are expected to continue Discounted super profit at a suitable rate
Super profit method
Annuity method
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Valuation of goodwill
COMPANY A Capital employed: Normal rate of return: Future maintainable profit:
Rs. 45 cr 12 % Rs. 5.5 cr
What would be the goodwill under the normal capitalization method? SOLUTION: = (5.5/0.12) 45 = Rs. 0.83 cr
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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: = [8 (50*0.15) ] * 3 = Rs.1.50 cr
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Valuation of Intangible Assets (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
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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
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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
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INCOME BASED METHODS
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Income Based methods
Earnings capitalisation method or profit earning capacity value (PECV)method Discounted cash flow method (DCF)
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Earnings capitalisation method
This method is also known as the Profit earnings capacity value (PECV) Companys 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 Problems: Arriving at Capitalisation Factor
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DCF Valuation A Brief View
Valuing a Company
Projecting its earnings for a specific period (Say 5 -10 years)
Estimating a value on what happens after the period (Terminal Value)
DCF Steps
Forecast of revenue & receivables Validating Assumptions Consider Product/Industry Life Cycle Industry specific factors Cost Of Sales & Inventory Debt & Equity Mix Terminal year
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DCF methods: Starting data
Free Cash Flow (FCF) of the firm Cost of debt of firm Cost of equity of firm Target debt ratio (debt to total value) of the firm.
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Template for Free Cash Flow
Working capital Year Revenue Costs Depreciation of equipment Profit/Loss from asset sales Taxable income Tax Net oper proft after tax (NOPAT) Depreciation Profit/Loss from asset sales Operating cash flow Change in working capital Capital Expenditure Salvage of assets Free cash flow 0 1 2
Income Statement
Noncash item Noncash item
Adjustment for for non-cash
Capital items
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Template for Free Cash Flow
Taxable income = Revenue - Costs - Depreciation + Profit from asset sales NOPAT = Taxable income - Tax Operating cash flow = NOPAT + Depreciation - Profit from asset sales Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure + Salvage of equipment - Opportunity cost of land + Salvage of land Adjustment of noncash items: Add the noncash items you subtracted earlier and subtract the noncash items you added earlier.
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Estimating Horizon
For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it. Since a company is assumed to have infinite life:
Estimate FCF on a yearly basis for about 5 10 years. After that, calculate a Terminal Value, which is the ongoing value of the firm. Estimate a long-term growth and use the constant growth perpetuity model. Use a Enterprise value to EBIT multiple, or some such multiple
Terminal value is calculated one of two ways:
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Weighted Average Cost of Capital (WACC)
WACC
Return to Equity Investors
Return to Debt Investors
WACC =
Cost of Equity x percentage of Capital in Equity + Cost of Debt x percentage of Capital in Debt
E D i.e. re ---------- + rd (1-t) --------------E+D E+D where E = the total market value of the companys equity D = the total market value of the companys debt re = the cost of equity rd = the cost of debt t = the companys effective tax rate re > r d
and
Calculating Terminal value
T = FVn (1+g)
r-g T = Terminal value
FVn = Forecasted Return in year n( final year of
forecast) g = Long term sustainable growth rate variable R = discount rate
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Arriving at Discount rate
Using Capital Asset Pricing Model
E(ri) = Rf + b [E(Rm)-Rf] Rf = Risk Free Rate b = Beta [E(Rm)-Rf] = Risk Premium Estimating Beta Ks required rate of return on the security Krf = Risk free rate (rate of return on risk free investment. E.g. [Link] = beta Km expected return on the over all stock market
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Principal difficulties with the DCF technique
Long-term cash flow projections are subject to errors. The choice of the discounting horizon, is also uncertain. The terminal value accounts for 60- 70% of the final valuation The projections are as good as the assumptions
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
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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
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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
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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
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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
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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
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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
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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.
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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
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MARKET BASED METHODS (Relative Valuation)
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Market based Methods
Sales Multiple EBIT Multiple P/E multiple Price to Book multiple Enterprise value to EBIDT multiple
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Valuation: P/E multiple
If valuation is being done for an IPO or a takeover,
Value of firm = Average Transaction P/E multiple EPS of firm Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be) Value of firm = Average P/E multiple in industry EPS of firm firms in the industry are profitable (have positive earnings) firms in the industry have similar growth (more likely for mature industries) firms in the industry have similar capital structure
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If valuation is being done to estimate firm value
This method can be used when
Valuation: Price to book multiple
The application of this method is similar to that of the P/E multiple method. Since the book value of equity is essentially the amount of equity capital invested in the firm, this method measures the market value of each rupee of equity invested. This method can be used for
companies in the manufacturing sector which have significant capital requirements.
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Valuation: Enterprise Value to EBITDA multiple
This multiple measures the Enterprise Value (EV), that is the value of the business operations (as opposed to the value of the equity). EV = MV(EQ)+ MV(Debt)+ MV(Pref Eq)- (Cash+ Investments) In calculating enterprise value, only the operational value of the business is included. Generally Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded.
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Sample Valuation based on market methods
A 1.4 17.0 20 B 1.1 15.0 26 C 1.1 19.0 26
Enterprise market value/sales Enterprise market value/EBITDA Enterprise market value/free cash flows Application to XYZ Co. Sales EBIDTA Free cash flow
Rs. 200 crores Rs. 14 crores Rs. 10 crores
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Value estimated
Enterprise market value/sales Enterprise market value/EBITDA Enterprise market value/free cash flows Application to XYZ Co. Sales EBIDTA Free cash flow A 1.4 17.0 20.0 B 1.1 15.0 26.0 C 1.1 19.0 26.0 Average 1.2 17.0 24.0
Rs. 200 crores Rs. 14 crores Rs. 10 crores
Average Value 1.2 Rs. 240 crores 17.0 Rs. 238 crores 24.0 Rs. 240 crores
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Exercise in Valuation
Enterprise market value/sales Enterprise market value/EBITDA Enterprise market value/free cash flows Application to PQR Co. Sales EBIDTA Free cash flow
D 2.6 10.0 21.0
E 1.9 21.0 30.0
F 0.9 4.0 24.0
Rs. 300 crores Rs. 15 crores Rs. 7.5 crores
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Value estimated ?
Enterprise market value/sales Enterprise market value/EBITDA Enterprise market value/free cash flows Application to PQR Co. Sales EBIDTA Free cash flow D 2.6 10.0 21.0 E 1.9 21.0 30.0 F 0.9 4.0 24.0 Average 1.8 11.7 25.0
Rs. 300 crores Rs. 15 crores Rs. 7.5 crores
Average Value 1.8 Rs. 540 crores 11.7 Rs. 175.5 crores 25.0 Rs. 187.5 crores
Can this be used as a dependable guide for valuation
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Companies in distress- Valuation
Analyse based on future expected transaction in which cash flow is identifiable Liquidation value Sum of parts based on individual identification of units
Consider all assets tangible and intangible
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Relative Valuation
Using fundamentals
Valuation related to fundamentals of business being valued
Using comparables
Valuation is estimated by comparing business with a comparable fit
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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
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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
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Applicability
Simple and easy to use Useful when data of comparable firms and assets are available
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Limitation
Easy to misuse Selection of comparable can be subjective Errors in comparable firms get factored into valuation model
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CCI Guidelines
These are used when shares are issued to Non residents by unlisted companies Compute Value using
NAV PECV
Fair Value is average of both above As per latest amendment in 2010, Free cash flow discounting method can be used
Value of equity
Value of equity = Enterprise value + Value of cash and investments - Value of debt and other liabilities
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Valuation Measurements in Various Industries
Industry Auto Banking
Best measure of value Price to Earnings (PE) multiple PE and Price to Book Value (PBV) or Adjusted PBV multiple
Cement
PE, Enterprise Value to Earnings before interest, tax, depreciation & amortisation (EV/EBITDA), EV/tonne Forward PE, which reflects the order book position of the company
Engineering
Industry FMCG
Best measure of value PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratios Net asset value (NAV), which is book value at market prices. Also look at debt levels PE and DCF, because there is a future stream of cash flows for upfront heavy investment Residual reserves of energy assets Trailing PE and its growth
Real Estate
Telecom
Oil & Gas Technology
What Affects Value in Industries
Industry Auto Banking Cement
Factors Impacting Volume growth, realisations, operating profit margins, new product launches Loan growth, non-performing assets, net interest margins, CASA ratio Dispatches, operating costs, regional demand supply equation
Engineering
Order book inflows, execution skills, margins RoE, RoCE, margins, volume growth, new products, market share
FMCG
Industry Real Estate
Factors Impacting Debt levels, liquid assets, inventory levels, promoters ability to raise funds Project costs, plant load factors, raw material costs, debt equity ratios OPEX , ARPU, TOWERS, debt equity ratios Project costs, debtequity ratios Order inflow, ability to contain costs, service verticals, profitability, client attrition
Utilities & Power Telecom Oil & Gas Technology
Finally
Valuing a business is not completely a science nor completely an art. While there are many known and time tested method of valuing businesses, at the end of the day there are a lot of subjective elements that play a huge part in the valuation process. Which method to be used .. Finally it all comes down to what the buyer is willing to pay.
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Good Quotes on Investing
The four most expensive words in the English language are, 'This time it's different." Sir John Templeton "The stock market is filled with individuals who know the price of everything, but the value of nothing." Philip Fisher
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One for the road
Valuation is both an art and a science, but too much of either is a dangerous thing. A person infatuated with measurement, who has his head stuck in the sands of the balance sheets, is not likely to succeed. If you could tell the future from a balance sheet, then mathematicians and accountants would be the richest people in the world by now."
-Peter Lynch
