Class on Valuation - Economics of Strategy

8/11/2019 Class on Valuation - Economics of Strategy

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Valuation (Economics of Strategy)By Gaurav Jalan, MD, Avant Garde Wealth Management

IMI Kolkata, December 9 2013


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Investor Presentation - 1104

BOS 2

What is valuation?

Valuation is simply the process of estimating the value of an

asset or a business

A cash flow or asset basedvalue of an operating

business

Value that can be realizedfrom sale of the asset or

business

Two primary ways to think about value

Operating value Strategic value

Theoretically, a prospective buyer should also value the asset/businessbased on its cash flows so these two methods should yield the same

result, but this is often not true in practice (more on this later)


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BOS 3

Replacement cost, ROIC and WACC

*Invested capital is ideally calculated using replacement cost but can be estimated usingbalance sheet values

ROIC = NOPAT / Invested Capital*

NOPAT (Net Operating Profit After Tax) = EBIT * (1 tax rate)

Invested Capital = Fixed assets + net working capital + intangibles (if appropriate)

ROIC (Return On Invested Capital)

The reproduction cost of an asset is the cost of reproducing its economic function asefficiently as possible Competition Demystified

Enterprise valuation of the business is equal to reproduction cost of the following

Fixed assets

Intangible assets

Working capital = Current assets Current liabilities

Equity value = Enterprise value Value of liabilities (debt + other LT liabilities)

Calculating replacement cost

Weighted average of cost of equity and cost of debt assuming a certain capital structure

In plain English, this is the return that an investor expects to earn on the investedcapital in this business and others with a similar risk profile

WACC (Weighted Average Cost of Capital)


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BOS 4

Appropriate valuation framework depends on businesseconomics

Key measure of economic viability of a business -> ROIC - WACC

ROIC WACC < 0

ROIC WACC = 0

ROIC WACC > 0

Unviable business

that is destroyingvalue by operating

Operating in aperfectly

competitiveenvironment

Business withcompetitiveadvantages

Liquidation value

Replacement cost

Earnings / cash flowbased valuation

Versusreplacement cost

Smaller

Equal

Greater

Businesseconomics

Businessdescription

Valuationframework


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BOS 6

Replacement value

If ROIC = WACC the business operates in economist heaven, a perfectly competitivelandscape where all excess profits are competed away

In this case the value of the business is exactly equal to the replacement cost of theassets as the capital invested in it is earning the same as it would elsewhere(adjusted for risk)

When is replacement value appropriate?

Given tendency for mean reversion, replacement cost is a good benchmark for valueeven if currently ROIC WACC

Unless sustainable competitive advantages can be identified there is a tendencyfor excess returns to shrink over time as competition increases

Unless there are reasons for permanent unviability, a business earnings lowreturns tends to improve over time as competition reduces

Key points to consider


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BOS 7

Cash flow based valuation

The value of an asset or a business is the net present value of the cash

flows that will be received by the owner over time

Two primary ways to calculate cash flow based valuation

Discounted cash flow Multiple based

Explicit forecasts of cash flows for acertain period + terminal value

Theoretically most appropriate

Drawbacks Very sensitive to terminal value

Explicit forecasts are likely to havelarge errors as well

Garbage in = Garbage out

Based on some multiple of a currentmeasurable value. E.g. Price/Earnings,Price/Cash Flow, Price/Earnings Power,EV/EBITDA, etc.

Metrics such as earnings or EBITDA aretypically used as a proxy for cash flow

Easy to calculate and easily comparableacross assets/industries/geographies

Primary drawback is that a currentperiod metric is effectively assumed toaccurately reflect a long term stream of

cash flows



BOS 8

The math behind multiple based valuation

Proxy for sustainable

free cash flowEnterprise value = Multiplex

Earnings power (as defined in Competition Demystified)

Earnings power = Normalized EBIT * (1 tax rate) +

Depreciation Maintenance Capex

Normalized EBIT = Sales * Normalized EBIT margin

In real life, due to easy availability, reported after tax earnings(despite the drawbacks) are often used as a crude proxy for cash flow

Note that a multiple on reported earnings leads to calculation ofequity value and not enterprise value

Multiple (without growth)

Multiple = 1 / WACC

E.g. 1/12.5% = 8x

Multiple (with growth)

Multiple = 1 / (WACC g), where g = perpetual growth rate

E.g. 1/(12.5%-6%) = 15.4x



BOS 9

The three tranches of value

Assumptions about a business:

Replacement cost = Rs.10 billion

Earnings power = Rs.2 billion

WACC = 12.5%

Perpetual growth rate = 6%

Rs.10 b

Rs.6 b

Rs.14.8 b

Rs.10 b

Rs.6 b

Rs.10 bReplacement cost of assets

Total valueEarnings

power valueReplacement

value

2

(12.5%-6%)

=2

12.5%

=

Free entryNo competitive advantages

Franchise value

Franchise value from current

competitive advantages

Value of growth

Only if the growth benefits from


Source: Framework from Figure 16.1 in Competition Demystified



BOS 10

Cummins India: High ROIC business

10%

20%

30%

40%

50%

60%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

ROIC (on avg capital invested) ROE (on avg equity)

ROE is consistently below ROIC because company has maintained a net cashbalance over the years

Hence WACC = Cost of Equity = 15% (lets work with this assumption for now)



BOS 11

Cummins India: Replacement cost

Balance sheet

(in Rs. Million) 2013 (Sep)

Net fixed assets 6,830

Current assets 21,142

Cash + liquid funds 8,340

Investments 700

Total assets 37,012

Current liabilities and provisions 9,728Deferred tax liability 307

Total liabilities 10,035

Total shareholders' equity 26,977

Total liabilities + SE 37,012



BOS 12


1997 2007 20102013

Se

Net fixed assets 1,291 1,817 3,337 6,830

Most of the fixed assets have been added in the last 3-4 years

Balance sheet





Investments 700

Total assets 37,012







BOS 13


1997 2007 20102013

Se

Net fixed assets 1,291 1,817 3,337 6,830

Most of the fixed assets have been added in the last 3-4 years

Balance sheet





Investments 700

Total assets 37,012





Replacement cost




Current liabilities and provisions (9,728)

Deferred tax liability (307)

Replacement cost 29,557



BOS 14

Cummins India: Recalculating ROIC

Note: Fixed assets revalued up from 2003 onwards

Even after adjusting value of fixed assets upward ROIC remains high and wellabove the WACC

10%

20%

30%

40%

50%

60%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

ROIC (on avg capital invested) ROIC (adjusted for fixed asset value)



BOS 15

Cummins India: The three tranches of value

Assumptions for Cummins:

Replacement cost = Rs.29.6 b

Rs.29.6 bRs.29.6 bRs.29.6 bReplacement cost of assets

Total valueEarnings


value

Free entry

No competitive advantages

Rs.30 b


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BOS 16

Cummins India: Earnings Power Value (1)

Let us assume that normalized EBIT margins are 16%

10%

12%

14%

16%

18%

20%

22%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EBIT % of sales EBIT % (97-14 avg) EBIT % (05-14 avg)


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BOS 17

Cummins India: Earnings Power Value (2)

EPV > Replacement cost as expected since ROIC > WACC

(in Rs. Million) 2013

Sales 45,894Normalized EBIT margin 16.0%

Normalized EBIT 7,343

Normalized tax rate 27.0% Some tax benefits due to exports

NOPAT 5,360

Assuming that Depreciation = Maintenance Capex

Earnings Power (2013) 5,360

Earnings Power (2014) 6,164 Assumed 15% growth rate

WACC 15.0%

Earnings Power multiple 6.7

Earnings Power Value (no growth) 41,096

Replacement cost 29,557

Franchise value (no growth) 11,540


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BOS 18




Earnings power = Rs.6.2 billion

WACC = 15%

Rs.29.6 b

Rs.11.5 b

Rs.29.6 b

Rs.11.5 b

Rs.29.6 bReplacement cost of assets

Total valueEarnings


value

Free entry


Franchise value



Rs.30 b

Rs.41 b


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BOS 19

Cummins India: Value of Growth (1)

From 1997 to 2014 (est) revenue and EBIT CAGR has been 12.1% and 13.7%respectively. However, assuming such high growth in perpetuity is likely

unrealistic

5%

10%

15%

20%

25%

30%

2007 2008 2009 2010 2011 2012 2013 2014

Revenue growth (10-yr CAGR) EBIT growth (10-yr CAGR)

Revenue CAGR (97-14) EBIT CAGR (97-14)


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BOS 20

Cummins India: Value of growth

When businesses have the ability to reinvest capital at an ROIC that issignificantly higher than WACC growth can create substantial value

The larger the spread between ROIC and WACC the more sensitive thevaluation will be to the rate of growth

(in Rs. Million) Low Base High

Earnings Power 6,164 6,164 6,164

WACC 15.0% 15.0% 15.0%

Growth rate 8.0% 10.0% 12.0%

Earnings Power multiple 14.3 20.0 33.3

Earnings Power Value (with growth) 88,064 1,23,289 2,05,482

Earnings Power Value (no growth) 41,096 41,096 41,096

Value of growth 46,967 82,193 1,64,385

2014


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BOS 21





WACC = 15%

Perpetual growth rate = 8-12%

Rs.29.6 b

Rs.11.5 b

Rs.47 b

to

Rs.164 b

Rs.29.6 b

Rs.11.5 b


Total valueEarnings


value

Free entry


Franchise value



Value of growth



Rs.30 b

Rs.41 b

Rs.88-205 b


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BOS 22





WACC = 15%

Perpetual growth rate = 8-12%

Rs.29.6 b

Rs.11.5 b

Rs.47 b

to

Rs.164 b

Rs.29.6 b

Rs.11.5 b


Total valueEarnings


value

Free entry


Franchise value

Franchise value from currentcompetitive advantages

Value of growth



Current enterprise value of the company (Dec 6 2013) is Rs.116 billion

Rs.30 b

Rs.41 b

Rs.88-205 b


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BOS 23

Cummins India: Actual valuation history

On actual reported earnings the stock has historically traded at a P/E of 10-30xwhich is not very different from our calculated multiple range of 14-33x

5

10

15

20

25

30

35

Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13

Price / Earnings (Trailing Twelve Months)


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BOS 24

What is valuation?

Valuation is simply the process of estimating the value of an

asset or a business

A cash flow or asset basedvalue of an operating

business

Value that can be realizedfrom sale of the asset or

business

Two primary ways to think about value

Operating value Strategic value

Theoretically, a prospective buyer should also value the asset/businessbased on its cash flows so these two methods should yield the same

result, but this is often not true in practice (more on this later)


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BOS 25

Cummins India: Strategic value?

The buyer will only sell when he thinks he can get a good price for the

asset If the assets are sold in an auction the buyer is likely to suffer from

winners curse

The buyer will knowingly pay some strategic premium for the businessover its operating value as it gives him control over the cash flows of thebusiness

The buyer may believe that he can run the business better (high revenues,lower costs) and hence generate higher cash flows from the same assets

There may be synergies with an existing business of the buyer

Strategic value -> The price an informed buyer would pay for theentire business if the company were up for sale

Unless it is a distress sale the strategic value can be expected to exceedthe operating value, often substantially, for the following reasons:


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BOS 26

Valuation is more art than science

Given the number of variables involved and the sensitivity of theresulting valuation to each variable it is possible to justify a very

wide range of valuation figures for most businesses

Guess how the following people will respond when you ask them to valuea certain stock (relative to its current price):

An analyst when he has just put out a buy rating (hint: undervalued)

An analyst who has a sell rating (hint: overvalued)

A fund manager who has recently sold the stock (hint: overvalued)

An investment banker who is tasked with finding a buyer for the company(hint: very undervalued)

A competitor who is trying to sell shares in an IPO (hint: undervalued)

The promoter, when he is in the process of selling some of his holdings(hint: undervalued)

The promoter, when he wants to price some ESOPs for himself in the nearfuture (hint: very overvalued)

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