Valuation for merger and
acquisition
March 2015
Flow of presentation
Valuation methodologies
Valuation in the context of Merger and Acquisition
Indian Regulatory Environment and Minority Interest
Safeguard
Valuation methodologies
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Valuation methodologies Business / Share
Asset based
Cash flow based
Book Value
Discounted Cash
Flow
Free cash flow to
firm (FCFF)
Free cash flow to
equity (FCFE)
Replacement Cost
Market based
Quoted Market Price
Comparable Listed
Multiples
Comparable
Transaction Multiples
Applicability of a particular methodology guided by:
Nature of industry
Stage of company (nascent / growth or mature)
Listed / unlisted In case of listed, whether frequently traded or not
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Asset Based Methodologies- Net Assets/
Replacement Value
Arrives at valuation of an entity in terms of Tangible Net Worth of the
entity as at valuation date
Issues Involved
Limitations
Fixed Assets Revalued or Book
Value?
Current Assets - Cost or
Realizable Value
Differences in Accounting Policies
in case of Merger or Relative
Valuations
Adjustments for Contingent
Liabilities
Fails to factor the value of
intangible assets like brands,
technical know-how,
distribution network etc.
Impacted by accounting
Assumes assets always
have profit generating value
Ignores Returns vs. Cost of
capital
Generally Not Suitable for Fair Valuation of Going Concerns
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Is NAV completely doomed?
Not really
A Loss-making
Company
A Company Making
Inadequate Return
on Capital
A Real-Estate
Company
Any Company
Facing Potential
Liquidation
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Comparable Multiple Method
Methodology involves three elements:
Comparable Companies
assessment of maintainable earnings
application of an appropriate multiple of comparable companies
identification and valuation of any surplus assets or liabilities
Global vs. Indian comparisons
Identifying direct comparables: Research on companies is the key
Accounting for size differentials
Accounting for differing operating conditions
Choice of multiples
Transaction vs. Stock Market Multiples
Sales vs. Profitability Multiples Vs. Capacity Multiples
Historical vs. Forward Multiples
Valuers judgment required for appropriate choice
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Choice of multiples
Sector
Multiple Used
Rationale
Manufacturing
EV/EBITDA
Often with normalized earnings
Growth firms
PEG ratio
Big differences in growth rates
Young growth firms with
losses
Revenue Multiples
What choice do you have?
Infrastructure
EV/EBITDA, Price/ Book equity
depending on industry and capital
structure
EV/EBITDA - Normalized profits can
be reasonably determined;
P/BV Since most of them are
capital intensive
Financial Services
Price/ Book equity
Marked to market
Retailing
Revenue multiples
Margins equalize sooner or later
Oil &Gas, Mining
Resource multiples (EV/resource)
Cash flows are directly related to
resources
Choice of multiple depends on the sector in which
the Company operates
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Comparable Multiple Method
Issues Involved
Identifying Comparable Set of
Companies
Difference in Size, Margins,
Operating Efficiencies
Differences in Accounting Policies/
Leveraging Risks
Limitations
Markets may not necessarily
value companies fairly at all
points of time
Adequate and reliable details for
transaction
multiples
not
available in most of the cases
Provides a good benchmark to test reasonableness
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Discounted Cash Flow (DCF) Method
Determines the net present value of underlying cash flows of the business
Not Impacted by accounting principles, as based on cash flows and not
book profits
Incorporates all factors relevant to business e.g.
Tangible and intangible assets
Current and future competitive position
Financial and business risks
Business Value = NPV (FCFs) = NPV (NOPLAT Incremental WC
Incremental Capex)
Considered to be the most logical method of valuation
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Equity versus firm
Equity valuation
Values the claims of the equity shareholders on the business
Operating cashflows are considered and adjusted for movements in debt (debt
taken, repaid and interest)
Discount rate used should only be the cost of equity capital
Appropriate when the company has stable leverage
Firm valuation
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Values the claims of the all the stakeholders (debt and equity) on the business
Operating cashflows are considered but movements in debt (debt taken, repaid
and interest) are not taken into consideration
Discount rate used should only be the weighted average cost of capital (equity +
debt)
Appropriate when the company has unstable leverage
DCF Method Some key points
Valuation is at a particular date- the valuation date
Preferably the date nearer to the date of the valuation workings
Cash Inflows
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Remember to take out non- operating cash flows
Non operating cash flows are best valued as surplus asset (discussed later)
Examples Interest on surplus funds, dividends, profit on sale of fixed assets
investments, liability write offs
DCF Method Some key points.. Contd.
Cash Outflows
Incremental working capital aligned with sales growth
Working capital improvements are possible, but difficult
Extremely important matter for high working capital companies
Sugar seasonal variations. Does EV include working capital?
Capital Expenditure
Incremental for Growth
Dont underestimate maintenance capex
Especially without margin adjustments
May not be immediate
Gross Asset value/ Asset life is a broad benchmark. However, cannot ignore technological
obsolescence
Income tax
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Is on PBIT (because WACC assumes post tax debt cost)
Actual rate for explicit period; Adjusted for future
Stretch explicit period till exemption periods are over; Or value tax benefits
separately
Weighted average Cost of Capital (WACC)
Discounting rate WACC
The Rate of Return that an Investor would require to be induced to invest in the
stream of future cash flows being discounted
Weighted Average
Cost of Capital
= Re X (E/(D+E)) + Rd x (1-t) X (D/(D+E))
Cost
The
of Debt Weighted average cost of debt
Debt- Equity weights are market based and not book based
One of the most important causes for Over valuation
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Some key points
Discount rate used should be consistent with both the riskiness and
the type of cashflow being discounted.
Equity versus Firm: cash flows to equity should be discounted with cost of
equity. Cash flows to the firm should be discounted with the cost of capital.
Currency: The currency in which the cash flows are estimated should also
be the currency in which the discount rate is estimated- USD discount rate
can not be used for rupee cash flows or vice versa
Nominal versus Real: For real cash flows (i.e., excluding inflation), the
discount rate should be real
More logical to use mid year discount rate
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Perpetuity Value/ Terminal Value
Perpetuity
value is the projected value of the business at
the end of the outlook period
It represents a means of obtaining a proxy for the value of
the future cash flows of the business after the end of the
outlook period
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Common Approaches to Perpetuity Value
Cash Flow approach (Gordon Growth method)
Take
forecast net cash flow for the last year of the outlook period
Divide above amount by r-g
r = Discount rate to be utilized
g = Long term forecast average annual rate of growth after outlook period
Capitalization of earnings/Exit multiple approach
Estimate
future maintainable annual EBITDA after the outlook period
Select an appropriate EBITDA multiple to apply to those earnings
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Adjustment for surplus assets and
contingent liabilities
Surplus assets Key characteristics
Not used for generation of profitability
Purchased out of past cash flows
Usually land/ properties/ investments
Be careful to separate surplus cash from operating cash
When an asset is surplus, any return generated by it should not be included in
operating cash flows
Contingent liabilities
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Usually tax cases
Good idea to take expert advice
DCF : Strengths and Limitations
Strengths
Limitations
Theoretically correct
Volume and complexity of assumptions
Forward looking
Adequacy of data
Incorporates risk and time value of
money
At times, extremely sensitive to small
changes in assumptions
Focuses on cash returns
Developing an understanding of the business is the key to a good DCF
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Valuation, Really a Call on Three factors..
Risk
Growth
How Much? How
Sustainable?
External/Internal Price
Risk
How Long?
Manageable/ Non
manageable
Mitigating Factors
Brand, Distribution
Value
Management Quality
Reputation, Competence, Vision, Corporate Governance
Premium to HDFC Bank
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Valuation in the context of Merger and
Acquisition
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Merger and Acquisition- Situations
Merger/Demerger
Merger
involves absorption of one company by another or amalgamation of two
companies to form a new company
Consolidation of businesses / entities to take synergy benefits
Demerger
involves transfer of identified business from one company to another
Vertical split of the company usually for Inviting investor in identified business
Acquisition
Business
slump sale/itemized sale
Usually for expansion of existing business
Share
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purchase
purchase
Focus on inorganic growth /strategic or non strategic investments
Valuation for merger and acquisition
Mergers
Relative value of their shares - rather than absolute value.
Value is determined
on going concern basis
on as is where is basis post merger synergies/benefits not to be considered
Demerger
Usually not required when demerged into wholly owned subsidiary/ company with
mirror shareholding
But if the demerger is into an existing operating entity, valuation is required
Acquisitions
Absolute valuation of shares- not relative valuation
Value is determined -
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on going concern basis
post merger synergies/benefits are considered
Swap ratio for merger / demerger
Since scheme of arrangement is filed in a court of law, it is generally accepted
to also give weight to NAV method even though it may not be the most
appropriate method
Supreme court HLL case (HLL and TOMCO merger)
Combination of three methods - NAV, Market Price and Earnings Capitalization
(comparable multiples)
Weights to different methods:
NAV
: 20%
Market price
: 40%
Earnings
: 40%
However, these are not definitive and may be modified, depending upon the
facts and circumstances of each case. However, weights given should be
explained and justified
SEBI
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Fairness Opinion from Category 1 Merchant Banker
Acquisition valuations can depart from fair
values ..
Buyers/ Sellers leverage
Competitive Positioning
Distress Sale Vs. Desperate Buy
Strategic Premium/ Discounts: Strategic Premium / Discount arises on
account of
Operational synergy- Incremental Revenues/ cash Flows
Financial synergy- reduce the debt costs
Loss in value to acquirer in case target is acquired by competition
Ability of acquirer to cut costs in the acquired company
Higher the quality of management, lower the scope for cutting costs
Same target can have different value in the hand of
different acquirers
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Minority Versus Controlling Interests
All things being equal, a controlling interest is worth more than a
minority interest
A holder of a minority interest generally has a passive investment and
cannot initiate a sale of assets or require a higher dividend payout
The holder of a controlling interest can influence corporate policy.
Corporate Governance is a key tool to reduce minority interest.
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The Three Levels of Value
Control Value
Control
Premium
Minority Interest
Discount
Marketable
Minority Interest Value
Marketability
Discount
Non Marketable
Minority Interest Value
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Controlling interests are
considered marketable in that
they can generally be sold.
However, controlling interests
are not marketable in the sense
of publicly traded minority
interests
Indian Regulatory Environment and Minority
Interest Safeguard
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Snapshot of Indian laws impacting M&A
Direct Tax
Indirect Tax
SEBI / SE Listing
Requirements
Accounting Standards /
GAAP
Competition Act
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Companies Act
Laws affecting
M&A
FDI & Exchange
Control
Stamp Duty
Minority interest safeguard- under
regulations especially SEBI
Valuation report from Independent
chartered accountant
May not required by CA firm if no
change in shareholding
Audit Committee approval on Scheme and
Valuation report
In addition to approval from
board of directors, BoD
Observation letter from stock exchanges
after comments from SEBI
Approval from SEBI after NOC from stock
exchanges
Majority votes from public shareholders
Additional shares allotted to
promoters*
Scheme involves listed company
and any other entity involving
promoters*
Listed company has purchased
shares of subsidiary intended to be
merged with itself, from promoters*
in the past
Required only under
three above
instances
Primarily process driven rather than controlling the valuation itself.
* Includes promoter group, related parties of promoter / promoter group, associates / subsidiaries of promoter / promoter group
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Minority interest safeguard- Valuer and
company role
Valuer
to be independent and resist influence from the companies
Extra careful especially when M&A involves related parties (e.g. increase of
stake)
Explain key factors to the BoD and audit committee
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Methods used/methods not used
Significant business plan assumptions
Significant valuation assumptions
WACC/Discount rate
Treatment of surplus assets/contingent liabilities
Basis of selection of comparable companies, valuation multiple
Companies Act 2013: Valuation Requirements
Section
Particulars
62 (1) c
Issue of shares to a non-member
230
Corporate debt restructuring situations
232
Swap ratio for mergers
236
Purchase of minority shareholders
192
Non cash transaction involving Directors
281/305/319/325
Winding up of company situations
Valuation to be done by Registered Valuer. However, Registered
Valuer Guidelines are still to be notified
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To sum up
Valuation, like beauty, lies in the eyes of the beholder
And like beauty, our perception of value changes
Depending upon situations, valuation can be Exactly
Wrong
or
Roughly correct (if you are lucky)
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Questions?
