Valuation
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. 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.
VALUATION PROCESS
Review and selection of the methods of valuation, Understanding of issues which impact valuation, Special situations and their impact on valuation
What is value? - Cost vs. Market Value- Historical vs. Replacement
Differs depending on need of person doing valuation buyer, seller, employee, banker, insurance company
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)
VALUATION METHODS
These can be broadly classified into: Cost based, Income based, Market based,
Valuation methods
COST BASED METHODS, Book value, Replacement value, Liquidation value
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
Current cost valuation- All assets are taken at current value and summed to arrive at value- This includes tangible assets, intangible assets, investments, stock, and receivables
VALUE = ASSETS - LIABILITIES
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
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
Current cost valuation: More difficulties -The Company is not a simple sum of standalone elements in the balance sheet- Organization capital is difficult to capture in a number this includes
Employees, Customer relationships, Industry standing and network capital, Etc
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, 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
Valuation of IA
The value of the IA is from - Economic benefit provided, Specific to business or usage
Have different aspects - Accounting value- Economic value- Technical value
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
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, Replacement value method, Cost of replacing existing business is taken as the value of the business, Liquidation value method, Value if company is not a going concern, Based on net assets or piecemeal value of net assets.
INCOME BASED METHODS
Earnings capitalization methodor profit earning capacity value method:- This method is also known as the Profit earnings capacity value (PECV), Companys value is determined by capitalizing 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.
Discounted cash flow method (DCF)
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
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
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, 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
Unutilized assets of business:-Cash flow reflects assets utilized by company, Unutilized and underutilized assets may not get reflected in the valuation model, This may be overcome by adding value of unutilized assets to cash flow. The value again may be on assumption of asset utilization or market value or a combination of these, Companies with patents or product options, Unutilized product options may not produce cash flow in near future, but may be valuable, This may be overcome by adding value of unutilized product using option pricing model or estimating possible cash flow or some similar method
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 , Firm will be more risky, how can this be captured?, Historical data will not be of much help
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, Historically, many M&As have not done as well as expected. Many times this has been attributed to valuation being too high. To minimize 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.
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
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
Using comparable
Valuation is estimated by comparing business with a comparable fit, 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
Using Comparable 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
Limitation: - Easy to misuse, Selection of comparable can be subjective, Errors in comparable firms get factored into valuation model
VALUATION: What it depends on
Valuation depends on :- Management team, Historical performance, Future projections, Project, product, USP, Industry scenario, Country scenario, Market, opportunity, growth expected, barriers to competition,
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)
Valuation depends on:- Strategic requirements and need for transaction, Demand / supply position, Flavor of the season
VALUATION: Process
Process of valuation
Net assets tangible and intangible, Financial data, Historical information, Company info, Industry info, Economic environment
Include elements of cash, costs, revenues, markets , Plan long term not short haul, Discount for risks, assign probabilities , Arrive at range
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?
The last mile Does the valuation reflect the picture you have of the business? , Would you be willing to pay this price?
In special cases
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, 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), 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. 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
A business unit is identified as one which can be split off as a standalone 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
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
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
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)
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 :- 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
Mergers/Acquisitions: - Rationale for the proposed transaction is to be understood
Synergy, Revenues, Costs, Intangibles, Control/ dominance in market, under valuation perceived (LBOs/LBIs)
Mergers/Acquisitions Studies show that generally acquired company shareholders gain
Reasons for failure: - Poor post acquisition management, over payment for target
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
Mergers/Acquisitions:- Overpayment could be because of a combination of these factors: Market potential - overoptimistic appraisal , Synergy overestimated, Due diligence inadequate, Bidding excessive, 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
Mergers/Acquisitions:- LBOs/LBIs, Initially high leverage, May be followed by rapid reduction in debt, This impacts business risk which will change, 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
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, 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)
Companies in distress: - May have one or all these problems, Negative cash flow, Unable to pay back debt, Liquidity crunch
Valuing the company based on expectation of turnaround:- Assume the company will be healthy soon and look at future based on a healthier past, Analyze based on future expected transaction in which cash flow is identifiable, 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 realizable value
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 ,Cross border transactions, Analyze 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, Cross border transactions, Consider impact of restrictions on transfer of currency, In place of FCF, multiples may also be used
View impact of accounting regulations on financials: -Provisions (pension), Goodwill (amortized or against equity), Revaluation of assets, Deferred taxes , Fx translations, Non-operating assets, Tax
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
Privatization:- 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
Implication of privatization:- 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
