Valuation

1
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.
2
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
AGENDA
Topic Slide no.
Background 6
Valuation methods 13
Cost based 16
Book value 18
24
Goodwill 28
Intangible assets 31
Replacement 32
Liquidation 33
Income based 35
Earnings 36
capitalisation DCF 43
MarketLimitations
based of DCF
52 4
AGENDA
Topic Slide no.
What value depends on 63

Valuation process 67
Special
situations Multi 75
business 84
M&A 91

Cyclic companies 94

Companies in distress 97

Cross border transactions 102

Privatisation
5
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?
6
VALUATION PROCESS

◇ Review and selection of the methods

of valuation
◇ Understanding of issues which
impact valuation
◇ Special situations and their impact
on valuation

7
What is value

◇ Cost vs. Market Value

◇ Historical vs. Replacement

◇ Differs depending on need of

person doing valuation – buyer,
seller, employee, banker,
insurance company 8
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

9
Complex nature of
valuation
Value A + Value B can be

greater
or
less
than

Value 10
Why Value
When do you think a company is
to be valued?

11
Why Value
To
◇ Purchase

◇ Sell
◇ Transact

◇ Take decisions

◇ Report

12
VALUATION METHODS

13
Valuation methods

These can be broadly classified into:

◇ Cost based
◇ Income based
◇ Market
based

14
Valuation methods

◇ Different experts have different

classifications of the various
methods of valuation
◇ Within these methods, there are
sub-methods
◇ Sometimes the methods overlap

15
1. COST BASED METHODS

16
Cost based methods

◇ Book value

◇ Replacement value

◇ Liquidation value

17
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 18
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
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 20

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? 21
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 22
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…
23
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

24
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

25
Valuation of goodwill

COMPANY A
◇ Capital employed: Rs. 45 cr
◇ Normal rate of return: 12 %
◇ Future maintainable Rs. 5.5 cr
profit:
◇ 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 26
Valuation of goodwill
COMPANY B
◇ Capital employed: Rs. 50 cr
◇ Normal rate of return: 15 %
◇ Future maintainable Rs. 8 cr
◇ profit:
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)
27
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? 28
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
29
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
30
Replacement value
method
◇ Cost of replacing existing business is
taken as the value of the business

31
Liquidation value method

◇ Value if company is not a going

concern
◇ Based on net assets or piecemeal
value of net assets

32
INCOME BASED METHODS

33
Income Based methods

◇ Earnings capitalisation method or

profit earning capacity value
method

◇ Discounted cash flow method

(DCF)

34
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 35
 Discounted cash flow
method
◇ Creame Corner wants Year Net CF 15%
disc.
to acquire Samosa Rs.
‘000
Specials for Rs. 10
million. The net cash 1 -10,000 1
flows are in the table 2 1,000 0.8696
below. Creame Corner 3 3,000 0.7561
wants to apply a 4 5,000 0.6575
discount rate of 15%. 5 6,500 0.5718
Should it buy Samosa
Specials?
36
Discounted cash flow
method
◇ NPV is positive Year Net CF 15% NPV
disc.
hence based on Rs. ‘000 Rs. ‘000

this method, the

answer is YES, the
1 -10,000 1 -10,000
acquisition should
2 1,000 0.8696 870
be made! 3 3,000 0.7561 2,268
◇ Can you think of 4 5,000 0.6575 3,288

three deficiencies 5 6,500 0.5718 3,717

in this valuation 5,500 142

method?
37
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

38
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

39
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

40
Discounted cash flow

t n

Value   CFt
t 1 (1
• CF is cash flow
r) t

• 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
41
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

42
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

43
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 44
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
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 46
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

47
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

48
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
49
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.
50
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

51
MARKET BASED METHOD

52
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
53
 Exercise in Valuation
Plantation Garden Co. Park Co.
Co.
Enterprise market value/sales 1.4 1.1 1.1

Enterprise market 17.0 15.0 19.0

value/EBITDA
Enterprise market value/free 20 26 26
cash flows

Application to Meadows
Co.
Sales Rs. 200 crores
EBIDTA Rs. 14
54
crores
www.venturebean.com
Value estimated

Plantation Garden Co. Park Co. Average

Co.
Enterprise market value/sales 1.4 1.1 1.1 1.2
Enterprise market 17.0 15.0 19.0 17.0
value/EBITDA
Enterprise market value/free 20.0 26.0 26.0 24.0
cash flows

Application to Meadows Average Value

Co.
Sales Rs. 200 1.2 Rs. 240 crores
crores
EBIDTA Rs. 14 17.0 Rs. 238 crores
crores
Free cash flow Rs. 10 24.0 Rs. 240 crores
crores 55
www.venturebean.com
Relative Valuation
◇ Using fundamentals
– Valuation related to fundamentals
of business being valued

◇ Using comparables
– Valuation is estimated by
comparing business with a
comparable fit

56
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
57
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
58
Applicability
◇ Simple and easy to use
◇ Useful when data of comparable
firms and assets are available

59
Limitation
◇ Easy to misuse
◇ Selection of comparable can be
subjective
◇ Errors in comparable firms get
factored into valuation model

60
VALUATION: What it depends
on

61
Valuation depends on
◇ Management team
◇ Historical performance
◇ Future projections
◇ Project, product, USP
◇ Industry scenario
◇ Country scenario
◇ Market, opportunity, growth
expected, barriers to competition
62
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)
63
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
64
VALUATION: Process

65
Process of valuation
Consider
◇ Net assets tangible and intangible

◇ Financial data
◇ Historical information

◇ Company info

◇ Industry info

◇ Economic environment

66
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
69
to a single number
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?
68
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?

69
Valuation: for investment
◇ Valuation is perception in the eye
of the beholder
◇ It is subject to negotiation

Investor Company
Value Value

70
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
71
APPLICATION OF
VALUATION MODELS

In special cases

72
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
73
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)
74
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 75
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
76
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
79
considered ‘arms length’
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
78
– Advertising and marketing
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

79
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)
80
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
regulatorypricing to be viewed in the
context 81
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
82
Mergers/Acquisitions
Rationale for the proposed
transaction is to be understood
◇ Synergy
– Revenues
– Costs
– Intangibles
◇ Control/ dominance in market
◇
Under valuation perceived
(LBOs/LBIs)
83
Mergers/Acquisitions

◇ Studies show that generally

acquired company shareholders
gain

◇ Reasons for failure

– Poor post acquisition management
– Over payment for target
84
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

85
Mergers/Acquisitions
Overpayment could be because of
a combination of these factors:
◇ Market potential - overoptimistic
appraisal
◇
Synergy – overestimated
◇
Due diligence – inadequate
◇
Bidding – excessive

86
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
87
Mergers/Acquisitions
◇ LBOs/LBIs
◇ Initially high leverage
◇ May be followed by rapid reduction
in debt
◇ This impacts business risk which
will change

88
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
consider as based. 91
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
90
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) 91
Companies in distress

May have one or all these problems

◇ Negative cash flow

◇ Unable to pay back debt

◇ Liquidity crunch

92
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
93
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 94
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
95
transactions
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
96
Cross border transactions
◇ Consider impact of restrictions on
transfer of currency
◇ In place of FCF, multiples may also
be used

97
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 100
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

99
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 100
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
101