CORPORATE VALUATION

“Value lies in the eyes of the beholder”

The objective of this note is to explore the realm of valuation in its entirety. The idea is to introduce the reader to a working knowledge of this subject as it has a very pertinent relevance to investment banking.

INTRODUCTION

Value maximization is the central theme in financial management.The goal of valuation is to estimate a fair market value of a company.

Fair market value: The price at which the property would change hands between a willing buyer & a willing seller when the former is not under any compulsion to buy & the latter is not under any compulsion to sell both parties having reasonable knowledge of relevant facts.

Before getting into the details of valuation, a word on price & value.

Price vs. ValueIn general terms price is a component of an exchange or transaction that takes place between two parties and refers to what must be given up by one party (i.e., buyer) in order to obtain something offered by another party (i.e., seller).

Value refers to the perception of benefits received for what someone must give up.

   Value = perceived benefits received                   perceived price paid

Valuation DefinitionValuation is the process to arrive at the present value of an asset or firm that has future earning potential.

Uses of valuation in Investment banking domainInvestment banking requires valuation of companies for a variety of transactions such as raising of capital through debt security issue, pricing of initial public offers & other types of equity offers, venture capital and private equity, equity buy-backs, delisting offers, LBOs, mergers & acquisition.

Valuations are of two types: Business/Corporate valuation & Security valuation

Business valuation: This method is used to value a company as an enterprise & derive the value of the underlying equity share there from. In this sense, business/ corporate valuation is about measuring the continuing value of a company’s business in today’s terms.Business/ Corporate valuation methodology assumes a “going concern1” concept for the company.Security valuation: Valuation of security such as bond/ debenture or a share of a company may be done purely from investor’s perspective by looking at the variables that measure such value.

Note: Debt & Equity valuation is not discussed.

Approaches to CORPORATE VALUATIONThere are four approaches to appraising the value of the company. They are

1. Adjusted book value approach2. Stock & Debt approach3. Direct comparison approach4. Discounted cash flow approach(DCF)

We will discuss these approaches in detail.

Note: No Example has been worked out.

ADJUSTED BOOK VALUE APPRAOCHPrinciple: the simplest approach in valuing a firm is to rely on the information found on its balance sheet. There are two equivalent ways of using the balance sheet information to appraise the value of the firm. First the book values of the investor claims2 may be directly summed. Secondly the assets of the firms may be totaled & from this total non-investor claim3 (like accounts payable & provision) may be deducted.

Types of adjusted book value approach Replacement cost Liquidation value or break-up value

Replacement Cost valuePrinciple: Replacement Cost value which tries to estimate how much it would cost to establish a company with similar assets at current prices.

Principles to arrive at Reflect Replacement cost1. Cash: Cash & cash equivalents are considered at their book value.2. Debtors: Debtors are valued at there face value.

1 Going concern concept: Accounting is normally based on the premise that the business entity will remain a going concern for an indefinitely long period.2 Investor claim= share capital(equity)+Reserves & surplus + Secured loans + Unsecured loan3 Non-Investor Claim=Total Assets(RHS of a balance sheet) – Current liabilities & provision

3. Inventories: Inventories may be classified into three categories: Raw- materials, work-in-process & Finished goods.

Raw-materials: Raw materials may be valued at their most recent cost of acquisition.

Work-in-process may be approached from the cost point of view( cost of raw material + the cost of processing) or from the selling price point of view(selling price of the final product --- expenses to be incurred in translating work-in-process into sales).

Finished goods inventory may be valued at their factory cost.4. Other current assets: other current assets like deposit, pre-paid expenses &

accruals are valued at their book value.5. Fixed tangible assets: Fixed tangible assets consist of mainly of land, building &

civil works & plant & machinery. Land is valued as if it is vacant & available for sale. Building & Civil works may be valued at replacement cost less physical

depreciation & deterioration. The value of plant & machinery may be valued at the market price of

similar (used) assets plus the cost of transportation & installation.6. Non-operating Assets: Assets not required for meeting the operating

requirements of the business are referred to as non-operating assets. The more commonly found non-operating are financial securities excess land & infrequently used buildings. These assets are valued at their fair market value.

Adjusted Book Values to Reflect Liquidation Values / Break-up valueLiquidation literally means turning a business's assets into readily available cash.

AssumptionThis approach makes sense only for a firm that is worth more dead than alive.

PrincipleLiquidation value or break-up vale of the equity share as it assumes that the company would be liquidated to realize.

CAUTION: What happens when there is no active secondary market for the business?Then the appraiser must try to estimate the hypothetical price at which the assets may be sold.

Break-up value per share = liquidation value of assets – Outstanding Debt.

Weakness It ignores organization capital. Instead of valuing the firm as a going concern it values it as collection of

assets to be sold individually.

APPLICATIONS These methods are applied to sick or financially distressed companies that do

not promise any future business model but have a significant underlying value of assets.

These valuations are relevant for companies that are capital intensive & are driven by assets. Example: Cement, Steel, metals etc.

What happens in case of companies that have a substantial amount of goodwill or brand value?

To handle these kind of situation use “VALUATION OF GOODWILL”. It consists of two methods:

Super profit method Normal capitalization method

METHOD 1: SUPER PROFIT METHODAssumptionUnder this method, it is assumed that the company generates super profits because of its goodwill. The value of the goodwill subsumes the value of all the intangibles that are embedded in the business of the company.

Step 1: The net capital employed in the business is completed.Capital employed = Net Fixed assets + Net Current Assets

ORCapital employed = Shareholder’s fund + Debt capital – Non-Cash reserves & fictitious assets. Step 2: The Return on Capital Employed (ROCE) is computed asROCE= Operating profit before interest on borrowing & taxes / Capital employed.

Step 3: the future maintainability of the ROCE is ascertained.

Step 4: The future maintainability ROCE is compared with the average of comparable companies in the industry as well as the industry average. By this comparison, the normal ROCE is determined.

Step 5: With the help of the normal ROCE, the operating profit of the company under the valuation required to generate the normal ROCE on its capital employed is determined. Let this be termed as the Required Operating Profit.

Step 6: The Required Operating Profit under Step 5 is reduced from the actual operating profit under Step 2 to arrive at the super profit.

Step 7: The super profit is capitalized for a given number of years which corresponds to the valuation horizon. This capitalizes value is the value of goodwill of the business.

Alternative Step 7: The super profit thus arrived at its discounted with an appropriate factor over the valuation horizon. The super profit may be assumed to be constant or growing at a substantial rate during this period. The Net present value of the super profits of each year thus discounted would be value of goodwill of business. This alternative is known as the “ANNUITY METHOD”.

METHOD 2: NORMAL CAPITALIZATION METHODPrincipleThis method is similar to method 1 expect that its uses the Normal Capital employed as the base for determined goodwill.

The steps outlined in method 1 until step 4. After that, the following may be used.

Step 5: The capital employed in the business of the company that can generate the Normal ROCE is determined as follows:

NORMAL CAPITAL = NORMAL ROCE X ACTUAL CAPITAL EMPLOYEDEMPLOYED ACTUAL ROCE

Step 6: The difference of the actual capital employed as reduced by the normal capital employed is the value of the goodwill of the company.

HOW TO ARRIVE AT THE FINAL VALUATION?In order to arrive at the total valuation of a company under the adjusted book value approach are:

1. The asset value as determined under any method (Replacement or liquidation method) discussed earlier is increased by the amount of the goodwill of the business to arrive at the final valuation.

2. Equity value of the company = Net Fixed assets + Net Current assets + Goodwill – Long term borrowings – Preference Capital.

3. Value per Share = Equity Value Number of Outstanding Shares

STOCK AND DEBT APPROACHPrincipleWhen the securities of a firm are publicly traded its value can be obtained by merely adding the market value of all its outstanding securities. This simple approach is called Stock & Debt approach. It is also referred as Market Approach.

IssuesWhat prices to use when valuing the securities particularly equity shares. Since stock prices are volatile.

Some appraisers suggest using average of recent stock prices rather than the price of the lien4 date.

DIRECT COMPARSION APPROACHAssumptionEconomic logic tells us that similar assets should sell at similar assets.

PrincipleOne can value an asset by looking at the price at which a comparable asset has changed hands between a reasonably informed buyer & a reasonably informed seller. This approach referred to as Direct Comparison Approach.

ApplicationReal Estate

FormulaThe direct comparison approach is reflected in a simple formula

VT = xT * (VC / xc)

WhereVT = appraised value of the target firm or assetXT = observed variable for the target firm that supposedly drives value.Vc = observed value of the comparable company or firmXc =observed value for the comparable company

Steps in applying direct comparison approachThe steps involved in this approach are

Analyze the economy Analyze the industry Analyse the subject company Select the comparable companies Analyse subject & comparable companies Analyse the multiples Value the subject company

Analyse the economyThe first step in the comparable company approach is to analyse the economy. The following factors & forecasting their growth rates: Gross national product, industrial production, agricultural output, inflation, interest rates, balance of payments, exchange rate & government budgets. Analyse the industry

4 Line date : The day on which the appraiser is attempting to value is called the lien date

This analysis should focus on the following: The relationship of the industry to the economy as a whole The stage in which the industry is in its life cycle. The profit potential of the industry The nature of regulation applicable to the industry The regulating competitive advantages of procurement of raw materials,

production costs, marketing & distribution arrangements, & technological resources.

Analyse the subject companyThe third step is to carry out an in-depth analysis of the competitive & financial position of Subject Company. The key aspects to be covered in this examination are as follows:

Product portfolio & market segments covered by the firm Availability & cost of inputs Technological & product capability Market image distribution reach & customer loyalty Product differentiation & economic cost position Managerial competence & drive Quality of human resources Competitive dynamics Liquidity leverage & access to funds Turnover margins & return on investments

Select Comparable CompaniesSelect the companies which are similar to the subject company in terms of lines of business, nature of market served, scale of operations & so on.

Analyse the financial aspects of the subject & comparable companiesOnce the comparable companies are selected the historical financial statements of the subject & comparable companies must be analysed to identify similarities & differences & make adjustments so that they put on a comparable basis. Adjustments many be required for differences in inventory valuation method, for intangible assets for off balance sheets items & so on. The purpose of these adjustments is to normalise the financial statements.

Choose the observable financial variableThe ratios or multiples that are commonly used in the direct comparison method are as follows:

Firm value to book values of assets Firm value to PBIDT Firm value to PBIT Equity value to equity earnings (P-E multiple) Equity value to net worth (Market-book ratio)

Value the subject companyThe final step in this process is to decide where the subject company fits in relation to the comparable companies. This is essentially a judgemental exercise. Once this is done, appropriate multiples may be applied to the financial numbers of the subject company to estimate its value.

Pros of this approach It is popular because it relies on multiples that are easy to relate to & can be

obtained easily & quickly.

Cons of this approach Multiples are amenable to misuse & manipulation The choice of “Comparable” companies is subjective The multiples used in this approach reflect the valuation errors (over valuation or

under valuation) of the market.

DISCOUNTED CASH FLOW APPROACH (DCF)

PrincipleThe discounted cash flow (or DCF) approach describes a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values. The discount rate used is generally the appropriate cost of capital and may incorporate judgments of the uncertainty (riskiness) of the future cash flows.

Very similar is the net present value.

Value of the firm = (Present Value of cash flow during an explicit forecast period) + (Present Value of cash flow after the explicit forecast period).

Thus the DCF approach to valuing the firm involves the following steps: Forecast the cash flow for the explicit forecast period Establish the Cost of Capital Determine the continuing value at the end of the explicit forecast period Calculate the firm value & interpret the results

Cash Flow Forecast During The Explicit Forecast PeriodFor obtaining the cash flow forecast during the explicit forecast period, the following steps may be followed:

Select the explicit forecast period Define the free cash flow to the firm Get a perspective on the drivers of free cash flow Develop the free cash flow forecast

Select the explicit forecast periodThe general guideline is that the explicit forecast period should be such that the business reaches a steady state at the end of the period.

Define the free cash flowThe free cash to the firm (FCFF) is the sum of the cash flows to all investors of the firm both lenders & shareholders. It can be decomposed as follows:

Operating free cash flowThe operating free cash flow is the post-tax cash flow generated from the operations of the firm after providing for investments in fixed assets plus net working capital required for the operations of the firm.FCF can be expressed as follows:FCF = NOPLAT – Net InvestmentFCF = (NOPLAT – Depreciation) – (Net Investment + Depreciation)FCF = Gross Cash flow – Gross Investment

NOPLAT stands for Net Operating Profit Less Adjusted TaxesNOPLAT = EBIT – Taxes on EBIT

EBIT = PBT + Interest Expense – Interest Income – Non-Operating Income

Taxes on EBIT = Tax Provision from the income statement + Tax shield on interest expense – Tax on Interest income – Tax on non-operating income

Net Investment = Gross Investment – Depreciation

Gross investment is the sum of the incremental outlays on capital expenditure & networking capital.

Depreciation refers to all non-cash charges.

If the Gross investment is not available then:

Net Investment = (Net fixed asset at the end of the year + net current asset at the beginning of the year) – (Net fixed asset at the beginning of the year + Net current asset at the beginning of the year).

Non-operating Cash Flow: Non-operating cash flow arises from the extra ordinary or exceptional items like profit from sale of assets, restructuring expenses & payment for settling from legal disputes.

Non-operating income * (1- Tax Rate) = Non-operating cash flow

FCFF = NOPLAT – Net Investment + Non-Operating cash flow

The FCFF equals is the cash flow available to investors which is also referred as FINANCING FLOW.

FINANCING FLOW = After- Tax Interest Expense+ Cash Dividend on Equity & Preference Capital+ Redemption of Debt- New Borrowings+ Share Buybacks- Share Issues+ Excess Marketable Securities- After- Tax income on excess market securities

GET A PERSPECTIVE ON THE DRIVERS OF FCFThe free cash flow may be analysed in terms of its key drivers as follows:

FCF = NOPLAT – Net Investment= NOPLAT (1- (Net Investment/ NOPLAT))= Invested Capital [(NOPLAT / Invested Capital)] [(Net Investment/ NOPLAT)]

FCF = Invested Capital [(NOPLAT / Invested Capital)] [(1- [(Net Investment/ Invested capital) / (NOPLAT / Invested Capital)]]

A word about the key drivers of FCF in order

Invested Capital = this is the capital invested in the operating assets of the firm comprising of fixed assets & net working capital.

NOPLAT / Invested Capital = This represents the ROIC

Net Investment/ Invested capital = This reflect the growth

DEVELOP THE FREE CASH FLOW FORECAST

Develop a credible sales forecast Rely on complete projections

Treat inflation consistently Look at the multiple scenarios

COST OF CAPITAL

Cost of capital is the discount rate used for converting the expected free cash flow into its present value.The formula is:

WACC = rE (S/ V) + rP (P/ V) + rD (1-T) (B/V)

Where WACC = weighted average of cost of capitalrE = cost of equity capitalS = market value of the equityV = market value of the firmRP = cost of the preference capitalP =market value of the preference capitalrD = pre-tax cost of debtT = marginal rate of tax applicableB = market value of interest-bearing debt

CONTINUING VALUEThe continuing value is based on the following assumptions

The firm earns a fixed profit margin achieves a constant asset turnover & hence earns a constant rate of return on the invested capital.

The re-investment rate & the growth rate remain constant

Value of the firm = PV of CF during the explicit forecast period + PV of CF after the explicit forecast period.

The second term represents the continuing value or the terminal value

There are two methods available for estimating the continuing value:1. Choose an appropriate method2. Estimate the valuation parameters & calculate the continuing value

Choose an Appropriate methodA variety of methods are available for estimating continuing value. They may be classified into two broad categories as follows:

CASH FLOW METHODS NON-CASH FLOW METHODSGrowing free cash flow perpetuity method Replacement cost methodValue driver method Price-PBIT ratio method

Market-to-book ratio method CASH FLOW METHODSGrowing free cash flow Perpetuity MethodThis method assumes that the free cash flow would grow at a constant rate for ever, after the explicit forecast period, T. Hence, the continuing value of such a stream can be established by applying the constant growth valuation model

CVT = FCFT+1 / WACC – g

Where CVT = continuing value at the end of the year TFCFT+1 = expected free cash flow for the first year after the explicit forecast

period.WACC = weighted average cost of capitalg = expected growth rate of free cash flow for ever.

Value driver methodThis method too uses the growing free cash flow perpetuity formula but expresses it in terms of value drivers as follows:

CVT = NOPLATT+1(1- g/r) / WACC-g

Where CVT = continuing value at the end of the year TNOPLATT+1 = Expected net operating profit less adjusted tax for the first year

after the explicit forecast periodWACC = constant growth rate of NOPLAT after the explicit forecast periodg = expected growth rate of free cash flow for ever.r= expected rate of return on net new investment

NON-CASH FLOW METHODS

Replacement cost methodPrincipleAccording to this method, the continuing value is equated with the expected replacement cost of the fixed assets of the company.

Limitations Only tangible assets can be replaced. It may be simply uneconomical for a firm to replace some of its assets. In such

case, their replacement cost exceeds their value to the business as a going concern.

Price-to-PBIT method

PrincipleA commonly used method for estimating the continuing the value is the price-to-PBIT ratio method. The expected PBIT in the first year the explicit forecast period is multiplied by a “suitable” price-to-PBIT ratio.

Limitations It assumes that PBIT drives prices. PBIT however is not a reliable bottom line for

purposes of economic valuation. There is an inherent inconsistency in combining cash flow during the explicit

forecast period with PBIT. There is a practical problem as no reliable method is available for forecasting

price-to-PBIT ratio.

Market-to-Book ratio method

Principle

According to this method, the continuing value of the company at the end of the explicit forecast period is assumed to be some multiple of its book value.It is analogous to the price-to-PBIT ratio.

Overall, it appears that the cash flow methods are superior to the non-cash flow methods.

Valuation ParametersIf the cash flow techniques are used for estimating the continuing value, the following parameters have to be estimated:

Net operating profit less adjusted taxes (NOPLAT) Free cash flow (FCF) Return on Invested capital (ROIC) Growth rate (g) Weighted average cost of capital (WACC)

FIRM VALUEThe value of the firm is equal to the sum of the following three parameters:

Present value of the free cash flow during the explicit forecast period. Present value of the continuing value (horizon value) at the end of the explicit

forecast period Value of non-operating assets (like excess marketable securities) which were

ignored in free cash flow analysis

What happens when we don’t get the year-to year forecasts?Then follow the simplified versions of DCF they are:

Two-stage growth model

Three-stage growth model

Two stage growth model

AssumptionsThe operating free cash flow (FCF) is equal to the free cash flow to the firm (FCFF). In other words, non-operating cash flow is nil.

PrincipleThe two stage growth model allows for two stages of growth-an initial period of higher growth followed by a stable (but lower) growth forever.

Value of the firm = present value of the FCF during the high growth phase + Present value of Terminal value

Steps involved in calculationsStep 1: Consider the following parameters from the given data:

1. Revenues2. EBIT3. EBIT(1-T)4. Cap exp- Dep5. Delta()Working capital(3-4)6. FCF (3-4-5)

Step 2: Length of High growth phase Step 3: Growth rate of revenues, Dep, EBIT, & Cap exp.

Step 4: The cost of equity (rE) using the capital asset pricing model (CAPM).Step5: Calculate the weighted average cost of capital.Step6: PV (FCF)Step7: PV (Terminal Value)Step 8: Value of firm = Step7 + step 8

Three Stage Growth ModelThe three stage growth model assumes that:

The firm will enjoy a high growth rate for a certain period The high growth period will be followed by a transition period during which

the growth rate will decline in linear increments The transition period will be followed by a stable growth rate forever.

Hence the value of the firm is expressed as follows:

Value of the firm = (PV of FCF during the high growth period) + (PV of FCF during the transition period) + (PV of the terminal value)

SUMMARY OF CORPORATE VALUATION

REFERENCE BOOKSFINANCIAL MANAGEMENT BY PRASANNA CHANDRAINVESTMENT BANKING FROM SUBRAMANYA

VALUATION

BUSINESS / CORPORATE VALUATION

LIQUDITY APPRAOCH

1. ADJUSTED BOOK VALUE APPRAOCH

REPLACEMENT COST

LIQUDITY APPRAOCH

BOND / DEBENTURE

EQUITY2. STOCK AND

DEBT APPROACH

3. COMPARABLE COMPANY

APPROACH

4. DISCOUNTED CASH FLOW APPROACH