Valuation Of
Business
1
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
2
Value…………
“Value like beauty lies in the eyes of the
beholder”
“Price is what you pay, Value is what you get”
Warren Buffet
3
Why Value
To
Buy
Sell
Transact
Take decisions
4
VALUATION PROCESS
Review and selection of the methods of
valuation
Understanding of issues which impact
valuation
Special situations and their impact on
valuation
5
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
6
Complex nature of valuation
Value A + Value B can be
greater
or
less than
Value (A+B)
7
Basic Principles in Business
Valuation
Value of a Business
Risk Involved
Expected Level
Expected Growth in
of
of such Benefits Receiving the Benefits
Economic Benefits
(discount rate)
Value is Based on Prospects
Examine the company’s
Past Performance
operational,
as
investment, and
Surrogate for Future
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 company’s
financial statements
Accuracy,
sustainability, and Composition of Capacity for
predictability of returns on equity continued investment
reported financial results
Steps in Valuation
Two Way Process
Data Collection
Data Analysis
Estimations & Validations
Value using various Methods
Applying Premiums/Discounts
Applying sanity checks
11
Computing value
Cost vs. Market Value
Historical vs. Replacement
Differs depending on need of person doing
valuation – buyer, seller, employee, banker
12
Valuation: What does
it depend on
13
Valuation depends on ….
Management team
Historical performance
Future projections
Project, product, USP
Country/ Industry scenario
Market, opportunity, growth expected,
barriers to competition
14
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
15
VALUATION METHODS
16
Valuation methods
Different experts have different
classifications of the various methods of
valuation
Within these methods, there are sub-
methods
Sometimes the methods overlap
17
Valuation methods
These can be broadly classified into:
Cost ( Asset) based
Income based
Market based (Relative)
18
COST BASED METHODS
19
Cost based methods
Book value
Historical Cost
Current Cost
Replacement value
Liquidiation Value
20
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
21
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
22
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
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…
24
Replacement value method
Cost of replacing existing business is taken
as the value of the business
25
Liquidation value method
Value if company is not a going concern
Based on net assets or piecemeal value of
net assets
26
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
27
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
28
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:
= (5.5/0.12) – 45 = Rs. 0.83 cr
29
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
30
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
31
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
32
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
33
INCOME BASED METHODS
34
Income Based methods
Earnings capitalisation method or profit
earning capacity value (PECV)method
Discounted cash flow method (DCF)
35
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
Problems: Arriving at Capitalisation Factor
36
DCF – Valuation
A Brief View
Valuing a Company
Projecting its Estimating a value
earnings on what happens
for a specific period after the period
(Say 5 -10 years) (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
38
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.
39
Template for Free Cash Flow
Working capital
Year 0 1 2
Revenue
“Income Statement”
Costs
Depreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flow
Change in working capital
Capital Expenditure Capital items
Salvage of assets
Free cash flow
40
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.
41
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.
Terminal value is calculated one of two ways:
Estimate a long-term growth and use the constant growth perpetuity
model.
Use a Enterprise value to EBIT multiple, or some such multiple
42
Weighted Average Cost of
Capital (WACC)
WACC
Return to Return to
Equity Investors 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 company’s equity
D = the total market value of the company’s debt
re = the cost of equity
rd = the cost of debt
t = the company’s effective tax rate
and re > r d
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
45
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]
β = beta
46
Km – expected return on the over all stock market
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
48
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
49
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
50
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
51
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
52
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
53
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
54
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.
55
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
56
MARKET BASED METHODS
(Relative Valuation)
57
Market based Methods
Sales Multiple
EBIT Multiple
P/E multiple
Price to Book multiple
Enterprise value to EBIDT multiple
58
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)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when
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
59
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.
60
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.
61
Sample Valuation based on
market methods
A B C
Enterprise market value/sales 1.4 1.1 1.1
Enterprise market value/EBITDA 17.0 15.0 19.0
Enterprise market value/free cash flows 20 26 26
Application to XYZ Co.
Sales Rs. 200 crores
EBIDTA Rs. 14 crores
Free cash flow Rs. 10 crores
62
Value estimated
A B C Average
Enterprise market value/sales 1.4 1.1 1.1 1.2
Enterprise market value/EBITDA 17.0 15.0 19.0 17.0
Enterprise market value/free cash flows 20.0 26.0 26.0 24.0
Application to XYZ Co. Average Value
Sales Rs. 200 crores 1.2 Rs. 240 crores
EBIDTA Rs. 14 crores 17.0 Rs. 238 crores
Free cash flow Rs. 10 crores 24.0 Rs. 240 crores
63
Exercise in Valuation
D E F
Enterprise market value/sales 2.6 1.9 0.9
Enterprise market value/EBITDA 10.0 21.0 4.0
Enterprise market value/free cash flows 21.0 30.0 24.0
Application to PQR Co.
Sales Rs. 300 crores
EBIDTA Rs. 15 crores
Free cash flow Rs. 7.5 crores
64
Value estimated ?
D E F Average
Enterprise market value/sales 2.6 1.9 0.9 1.8
Enterprise market value/EBITDA 10.0 21.0 4.0 11.7
Enterprise market value/free cash flows 21.0 30.0 24.0 25.0
Application to PQR Co. Average Value
Sales Rs. 300 crores 1.8 Rs. 540 crores
EBIDTA Rs. 15 crores 11.7 Rs. 175.5 crores
Free cash flow Rs. 7.5 crores 25.0 Rs. 187.5 crores
Can this be used as a dependable guide
for valuation 65
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
66
Relative Valuation
Using fundamentals
Valuation related to fundamentals of business
being valued
Using comparables
Valuation is estimated by comparing business
with a comparable fit
67
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
68
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
69
Applicability
Simple and easy to use
Useful when data of comparable firms and
assets are available
70
Limitation
Easy to misuse
Selection of comparable can be subjective
Errors in comparable firms get factored
into valuation model
71
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
73
Valuation
Measurements in
Various Industries
Industry Best measure of value
Auto Price to Earnings (PE) multiple
Banking 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
Engineering Forward PE, which reflects the order
book position of the company
Industry Best measure of value
FMCG PE, Return on Equity (RoE) and Return
on Capital Employed (RoCE) ratios
Real Estate Net asset value (NAV), which is book
value at market prices. Also look at debt
levels
Telecom PE and DCF, because there is a future
stream of cash flows for upfront heavy
investment
Oil & Gas Residual reserves of energy assets
Technology Trailing PE and its growth
What Affects Value in
Industries
Industry Factors Impacting
Auto Volume growth, realisations, operating
profit margins, new product launches
Banking Loan growth, non-performing assets,
net interest margins, CASA ratio
Cement Dispatches, operating costs, regional
demand supply equation
Engineering Order book inflows, execution skills,
margins
FMCG RoE, RoCE, margins, volume growth,
new products, market share
Industry Factors Impacting
Real Estate Debt levels, liquid assets, inventory
levels, promoters’ ability to raise funds
Utilities & Project costs, plant load factors, raw
Power material costs, debt equity ratios
Telecom OPEX , ARPU, TOWERS, debt equity
ratios
Oil & Gas Project costs, debtequity ratios
Technology Order inflow, ability to contain costs,
service verticals, profitability, client
attrition
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.
80
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
81
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
