Valuations

For Merger Acquisitions and Joint Ventures

Valuations

• An Exercise carried out during– M&A process– Listing– Private Equity– General Purpose Evaluation

Objective of Valuation

• To Arrive at an approximate value of a going concern

• To identify the potential and derivate the value of tangibles and intangibles

• To assign monetary aspect to promoters skill, trust and confidence

Methods• DCF

– FCFE– FCFF

• Comparable Companies / Relative Method– Multiples assigned to Sales– Multiples assigned to EBITDA– P/E

• Methodology based upon business• Replacement Value• Net Adjusted Asset Values

Valuation methods

These can be broadly classified into:

• Cost based• Income based• Market based

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Income Based methods

• Earnings capitalisation method or profit earning capacity value method

• Discounted cash flow method (DCF)

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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MARKET BASED METHOD

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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

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Relative Valuation• Using fundamentals

– Valuation related to fundamentals of business being valued

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

fit

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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

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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

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Applicability• Simple and easy to use• Useful when data of comparable firms and assets are

available

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

model

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VALUATION: What it depends on

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Valuation depends on

• Management team• Historical performance• Future projections• Project, product, USP• Industry scenario• Country scenario• Market, opportunity, growth expected, barriers to

competition

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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)

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Valuation depends on• Strategic requirements and need for transaction• Demand / supply position• Flavour of the season

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Initial ballpark valuation can alsobe a deal issue

VALUATION: Process

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Process of valuation Consider• Net assets tangible and intangible• Financial data• Historical information• Company info• Industry info• Economic environment

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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

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A valuation range is preferable to a single number

Process of valuationFinally after arriving at the value rangeraise 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?

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Process of valuationThe last mile…

• Does the valuation reflect the picture you have of the business?

• Would you be willing to pay this price?

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

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InvestorInvestorValue

CompanyCompanyValue

Valuation: in M&A• Value of combined business is expected to be more than

value of the individual companies

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Value (A+B)Value (A+B)

Value A + Value BValue A + Value B

APPLICATION OF VALUATION MODELS

In special cases

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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

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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)

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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

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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

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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 considered ‘arms length’

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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– Advertising and marketing costs

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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

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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)

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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 pricing to be viewed in the regulatory context

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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

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Mergers/AcquisitionsRationale for the proposed transaction is to be understood

• Synergy – Revenues– Costs– Intangibles

• Control/ dominance in market• Under valuation perceived (LBOs/LBIs)

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Mergers/Acquisitions

• Studies show that generally acquired company shareholders gain

• Reasons for failure– Poor post acquisition management– Over payment for target

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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

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Mergers/AcquisitionsOverpayment could be because of a combination of these factors:

• Market potential - overoptimistic appraisal • Synergy – overestimated• Due diligence – inadequate• Bidding – excessive

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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

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

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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

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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

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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)

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Companies in distress

May have one or all these problems• Negative cash flow• Unable to pay back debt• Liquidity crunch

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Companies in distressValuing 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

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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

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Disclaimer :• Unless otherwise specifically stated, the information

contained herein is made available to the readers and user by BizexIndia.com and Bizex Advisors Private Limited for their understanding of commercial transactions and may not reflect the realities of an actual transaction.

• Neither the BizexIndia.com and Bizex Advisors Private Limited nor any other agency or entities thereof, assumes any legal liability or responsibility for the accuracy, completeness, or usefulness of any information or process disclosed in these templates.