Valuation

Anjana Vivek

Rs. www.venturebean.com
beanie@venturebean.com
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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.
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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. 3
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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 4
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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?
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VALUATION PROCESS


Review and selection of the methods
of valuation

Understanding of issues which
impact valuation

Special situations and their impact
on valuation

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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

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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

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Complex nature of
valuation
Value A + Value B can be

greater
or
less than

Value (A+B)
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Why Value
When do you think a company is
to be valued?

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Why Value
To

Purchase

Sell

Transact

Take decisions

Report

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VALUATION METHODS

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Valuation methods

These can be broadly classified into:


Cost based

Income based

Market based

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Valuation methods


Different experts have different
classifications of the various
methods of valuation

Within these methods, there are
sub-methods

Sometimes the methods overlap

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1. COST BASED METHODS

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Cost based methods


Book value


Replacement value


Liquidation value

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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

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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? 19
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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

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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?

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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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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

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

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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
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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 27
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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?
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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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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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INCOME BASED METHODS

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Income Based methods


Earnings capitalisation method or
profit earning capacity value
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)

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
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 Discounted cash flow
method

Creame Corner wants to Year Net CF 15%
acquire Samosa Specials Rs. ‘000 disc.
for Rs. 10 million. The net
cash flows are in the table
below. Creame Corner 1 -10,000 1
wants to apply a discount 2 1,000 0.8696
rate of 15%. Should it buy
3 3,000 0.7561
Samosa Specials?
4 5,000 0.6575
5 6,500 0.5718

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Discounted cash flow
method

NPV is positive hence Year Net CF 15% NPV
based on this method, Rs. ‘000 disc. Rs. ‘000
the answer is YES, the
acquisition should be
made!
1 -10,000 1 -10,000

Can you think of three 2 1,000 0.8696 870
deficiencies in this
valuation method? 3 3,000 0.7561 2,268
4 5,000 0.6575 3,288
5 6,500 0.5718 3,717
5,500 142

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Applicability of DCF
method

Cash flow to equity
– Discount rate reflects cost of equity


Cash flow to firm
– Discount rate reflects weighted
average cost of capital

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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

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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

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Discounted cash flow

t n
CFt
Value  
t 1 (1  r )
t

• 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
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 Applicability


Discounted cash flow is based on
expected cash flow and discount
rates

Sometimes it is difficult to get a
reliable estimate for the future and
the valuation model may need
modification

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 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 METHOD

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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
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Exercise in Valuation

Plantation Co. Garden Co. Park Co.

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 Meadows Co.

Sales Rs. 200 crores
EBIDTA Rs. 14 crores
Free cash flow Rs. 10 crores

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Value estimated

Plantation Co. Garden Co. Park Co. 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 Meadows 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

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Exercise in Valuation

Papers Co Docs Co. Prints Co.

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 PenPencil Co.

Sales Rs. 300 crores
EBIDTA Rs. 15 crores
Free cash flow Rs. 7.5 crores

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Value estimated ?
Papers Co Docs Co. Prints Co. 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 PenPencil 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
Since multiples differ, this cannot be
used as a dependable guide for valuation57
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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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VALUATION: What it depends
on

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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
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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)

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Valuation depends on

Strategic requirements and need for
transaction

Demand / supply position

Flavour of the season

Initial ballpark valuation can also

be a deal issue
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VALUATION: Process

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Process of valuation
Consider

Net assets tangible and intangible

Financial data

Historical information

Company info

Industry info

Economic environment
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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

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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?
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Process of valuation
The last mile…


Does the valuation reflect the
picture you have of the business?


Would you be willing to pay this
price?

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Valuation: for investment

Valuation is perception in the eye
of the beholder

It is subject to negotiation

Investor Company
Value Value

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Valuation: in M&A

Value of combined business is
expected to be more than value of
the individual companies

Value (A+B)

Value A + Value B
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APPLICATION OF
VALUATION MODELS

In special cases

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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
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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)
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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
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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
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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’
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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
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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

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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)
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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
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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
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Mergers/Acquisitions
Rationale for the proposed
transaction is to be understood

Synergy
– Revenues
– Costs
– Intangibles

Control/ dominance in market

Under valuation perceived
(LBOs/LBIs)
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Mergers/Acquisitions


Studies show that generally
acquired company shareholders
gain


Reasons for failure
– Poor post acquisition management
– Over payment for target
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Mergers/Acquisitions

Research has suggested that the
following factors have resulted in
positive deals
– Bigger value creation overall
– Lower premiums paid
– Better run by acquirers

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Mergers/Acquisitions
Overpayment could be because of
a combination of these factors:

Market potential - overoptimistic
appraisal

Synergy – overestimated

Due diligence – inadequate

Bidding – excessive

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Mergers/Acquisitions

Synergy
– Operational (vertical and horizontal
M&A eg backward integration, captive
customer)
– Functional (Production, sales)
– Benefits (tax, control etc.) and impact
on cash flow to be quantified (eg.
increased sales, reduced wages)
keeping timing in mind
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Mergers/Acquisitions

LBOs/LBIs

Initially high leverage

May be followed by rapid reduction
in debt

This impacts business risk which
will change

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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
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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
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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)
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Companies in distress

May have one or all these problems


Negative cash flow

Unable to pay back debt

Liquidity crunch

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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
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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
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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
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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
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Cross border transactions

Consider impact of restrictions on
transfer of currency

In place of FCF, multiples may also
be used

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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
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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

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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
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Privatisation

Implication of privatisation

Reduced access to finance

Reduced visibility of company (impact
on brand)

Reduced requirement for
compliance/governance

Impacts to be factored in for valuation,

to the extent possible
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