Presentation on Valuation PGP16

VALUATIONRajesh S Upadhyayula

TABLE OF CONTENTS Valuation Rules Synergy Valuation Cross Border Issues in Valuation

VALUATION “Everything that can be counted

does not necessarily count; everything that counts cannot necessarily be counted” - Albert Einstein

“A walk of a thousand miles begins with a single step” – Chinese Proverb

VALUATION – RULE #1Think like an investor

Look to the future and not the pastFocus on Economic Reality – Rely on flows of

cashGet paid for the risks you takeTime is moneyOpportunity Cost

Consider alternative strategies for the buyer and seller

Information is the source of advantage Focus on what you know about a target company

that the market does not already knowDiversification is good

VALUATION – RULE #2Intrinsic value is unobservable –

we can only estimate it Results of valuation analysis are

estimates – vantage points only Entire process of valuation analysis is

structured as a triangulation exercise from several vantage points

Do not work with point estimates of values; work with ranges

VALUATION – RULE #3An opportunity to create value

exists where price and intrinsic value differs

Buyer’s view: Accept the proposal if: Intrinsic value of target to the buyer > Payment

Seller’s view: Accept the proposal if: Payment> Intrinsic value of target to the seller

ValueEnterprise = Equity + Debt

SUMMARY FLOWCHARTCash flows

Terminal Value

Cost of CapitalDCF Estimates

Venture Capital / Private Equity ApproachMultiple Estimates•Peer firms•Comparable Transactions

Option based EstimatesCurrent Market Value

Book ValueLiquidation Value

Replacement Value

WACC==id(1-t)Wd+KeWe

Triangulation of

Estimates

Sens

itivit

y Ana

lysis

VALUATION – RULE #4So many estimators – so little time – it helps to

have a view Book Value of the target firm

Principle of conservatism that tends to reflect only what has already happened

Ignores most assets or values that are not tangible These approaches are backward looking Appropriate for firms with no intangible assets, commodity

type assets with stable operations Liquidation value of the target firm

It is the most conservative approach – since it sums the value to be realized in the event of liquidation

Liquidation is equivalent to what price it fetches in auction Lowest of all the values Relies on estimators valuation method. Ignores the valuation

of hidden rights

VALUATION – RULE #4So many estimators – so little time – it

helps to have a view Replacement cost of the target firm

Useful in high inflation environments It reflects current conditions than past experience Ignores expectations of future performance Intangible assets are difficult to value using this method

Current market value of the target firm Sum of market values of debt and equity Value of equity is share price times the number of shares

outstanding Value of debt is the book value unless credit rating has

changed since the issuance of debt Approach useful for less well known companies with thinly

or intermittantly traded stock

VALUATION – RULE #4So many estimators – so little time – it

helps to have a view Trading multiples of comparable firms applied

to the target Application of multiples of peer firms to the target Some multiples value the whole enterprise while

others estimate the value of equity Rarely, one can find a pure play peer on which to

base a valuation Accounting practices across the firms can be

different and thus can be erroneous Method focus on proxies for cash flows

VALUATION – RULE #4 Discounted cashflow of the target firm

Estimate the residual or free cash flow and discount appropriately

Are the cash flows net of interest and principal payments – if so they are equity cash flows

Growth is the “big enchilada” of valuation. Terminal value is thus very important. Pay careful attention to the terminal value

Value of Cash Flow Terminal Value Discount RateFirm or Assets FCF=[EBITX(1-t)

+Depreciation – Capex -∆NWC +∆Def Taxes

FCF (1+g)/WACC-g Weighted average cost of capital

Equity RCF=Netincome + depreciation – capex - -∆NWC +∆Def Taxes +∆Debt

RCF (1+g)/K-g Cost of equity

Debt Interest, fees, Principal

Principal outstanding at maturity

Cost of debt

VALUATION – RULE #4 Discounted cashflow of the target firm

Discount Rate should reflect the investor’s opportunity cost on assets of comparable risk

WACC=id(1-t)Wd+KeWeEstimation of Cost of equity and Cost of Debt

after merger are importantKe=Rf+ß(Rm-Rf) If the acquirer intends to change the financial

leverage of the target significantly, beta should be adjusted

ßunlevered=ßlevered/(1+(1-t)D/E)ßlevered=ßunlevered(1+(1-t)D/E)

VALUATION – RULE #4 Discounted cashflow of the target firm

Not tied to historical accounting values and is forward looking

It focus on cash flows and not profits. It recognizes time value of money

It can be used to value enterprise or equity One can also use a method called as Adjusted

Present Value i.e., Value of Enterprise = Value of enterprise with no

debt + Present value of debt tax shields FCF and RCF need to explicitly model the cost of

capital changes over time as the terms of financing changes, whereas in APV the analyst need not

Choosing the approach is a matter of taste, convenience and data availability

VALUATION – RULE #4 Venture Capital / Private Equity Approach

Projects the performance of firm into the future Assumes that the private equity investor would exit in three to five

years Exit value at the horizon is estimated using an exit mulitiple Exit values are discounted at 30 – 75 percent Two important parameters are exit value and timing

Option Valuation approach Equity is viewed as a call option It requires knowing atleast five parameters

Value of the underlying asset. In the case of firms, this is enterprise value Exercise price of the call option. In case of firms, this is the par value of the

debt outstanding The term of the option. In the case of the firms, this is the duration for debt

outstanding The risk free rates. This is yield to maturity on government bonds Volatility of returns on the underlying assets

Approach is useful when the firm is highly levered Disadvantage is that one needs to have a view on enterprise value

VALUATION – RULE #5 Exercise estimators of intrinsic value to

find key value drivers and betsAnalysts should define the reasonable

rangeTo identify the key drivers or assumptions to

which the estimates are most sensitiveFour approaches for sensitivity

Univariate and bivariate sensitivity analysis Scenario analysis Break even analysis Monte Carlo Simulation

VALUATION – RULE #6 Think Critically; Triangulate carefully

There are several possible valuation approaches. No approach is flawless.

DCF is the approximate best what it means to think like an investor and deserve more weight

Be flexible and adapt your view to circumstances It would be different for businesses like trading operations,

firms in financial distress, assets to be liquidated and higher inflation settings

Scrutinize Sensitivity assumptions Eliminate estimates in which one has little confidence Compare the finalist estimates of value (Read HP Compaq) Opening bid and walk away bid needs to be defined –

Judgemental Other terms also determine the price especially deal terms, form

of payment, bargaining strategy

VALUATION – RULE #7 Focus on Process Not Product

No substitute for quality of information obtained through primary research or due diligence

Scrutiny of assumptions and critical thinkingDogged persistence to test and sensitizeFeedback followed by refinementThoughtful triangulation from many

estimatorsAcceptance of estimates, not certainty

Synergy Valuation

VALUING SYNERGIES True synergies create value for shareholders by

harvesting benefits from mergers that they would be unable to gain on their own Most of the M&A transactions occur among privately held

firms Growing cross border deals

Synergy assessment is center piece of M&A analysis Value creation should be a fundamental aim of M&A

transaction design Assessing synergies addresses an extremely important

tactical problem for the designer – anticipate reactions Valuing synergies in a deal can help an analyst to develop

a strategy for disclosing them to investors and shaping their understanding

Valuing synergies should be a foundation for developing a strategy for post merger integration

SYNERGY ANALYSIS Vsynergies= Vin place synergies+ Vreal options synergies Inplace synergies are reasonably predictable whereas real

option synergies are notVsynergies= ∑FCFt/(1+WACC)t

Synergies can arise due to improvements in either FCF components (i.e., after tax operating profit, plus non cash deductions, less investments in networking capital and capital projects) or WACC

Improvements include Revenue enhancement synergies Cost reduction synergies – This is the most credible of all the

synergies Asset reduction synergies – these are one time and not recurring Tax reduction synergies

Increase in depreciation tax shields Transfer of net operating losses from target to buyer

Financial synergies Does financing creates value for investors that they cannot create for

themselves? Simply financing a deal doesn’t do anything that investors cannot do

themselves – WACC optimization will not meet the economic definition of synergy

Combining two cash flow streams that are less than perfectly correlated can produce a joint stream that is less risky than a simple sum of streams

SYNERGY ANALYSIS Real Option Synergies

Growth option synergies: It would give a right but not an obligation to grow. Examples include R&D / Creative capabilities

Exit option synergies: A merger may make Newco less path dependent

Options to defer: A combination of two firms could grant the flexibility to wait on developing a new technology, entering a new market or undertaking a risky action

Option to alter operating scale: A combination of two firms could help the buyer to exit or enter a business more readily

Options to switch: Ability to change the mix of inputs or outputs of the firm or its processes

ESTIMATING SYNERGY VALUE

Establish credibility of the synergy source: Requires careful due diligence and research

Everything after tax Revenue or cost synergies are pretax Asset reduction synergies entail profit or loss WACC related synergies need to reflect marginal tax rate too for

newco Choose a discount rate consistent with the risk of the synergy

Cost synergies are most certain and revenue synergies are least certain

Tax reduction and asset reduction synergies are more certain than others

WACC synergies are probably in between Possible approaches to discount rate

“sure things” could be discounted at risk free rate Cash flows that are as variable as EBIT could be discounted at the

cost of debt Cash flows that are as risky as free cash flows of the enterprise

could be discounted at WACC Cash flows that are as risky as residual cash flows of the firms

should be discounted at firm’s cost of equity Cash flows that are speculative should be discounted at Venture

capitalists required rate of return

ESTIMATING SYNERGY VALUE “Many managers are apparently over exposed in impressionable

childhood years to the story in which the imprisoned handsome prince is released from the toad’s body by a kiss from the beautiful princess. Consequently, they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they’d pay if they made direct purchases on their own. In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the served many kisses, those kisses better pack some real dynamite. We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses even after their corporate backyards are kneedeep in unresponsive toads” – Warren Buffet

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VALUING FIRMS ACROSS BORDERS Cross border M&A is different

Tools and concepts of valuation and strategy remain relevant

Factor differences in inflation, currency, taxes, accounting, law and culture

There are two ways to value One can value a target in foreign local terms or in home

terms – adjusting for differences in currency. The investment attractiveness should be the same

(interest rate parity) Assuming no political or segmentation risk (will cover

later) Adjustments in cashflows or discount rates

Way to accommodate cross border differences in valuation is to adjust the cashflows or the rate which to discount them

FACTORS AFFECTING VALUATION OF FIRMS ACROSS BORDERS Inflation Foreign currency exchange rates Tax rates Timing of cash remittance Political risk Market segmentation Governance Accounting prinicples Social / Cultural issues

INFLATION Entry into a foreign country entails a

“bet” on the macro economic policies of that country

Policies can produce widely differing inflation rates and exchange rate uncertainty

Differences affect forecasted local cash flows and local discount rates

Thus real cash flows or discount rates get affected

FOREIGN CURRENCY EXCHANGE RATE Analyst must confront differences between

foreign currency and home currency Drawing upon theories of interest rate parity

and fisher equation, economists suggest a relationship between inflation rate differences between two countries and exchange rate differences

SPOTLocal/home / FWDlocal/home = (1+RLocal)/(1+RHome) Assumes that there are “no arbitrage”

opportunities available to investors. Investors are allowed to move freely in and

out of these two markets

TAX RATES Marginal tax rate varies substantially across

countries Rule: Choose the marginal tax rate appropriate to the

country in which the cash flows are generatedTerritorial tax system: Home country exempts further

taxation on local country’s income. Analysts argue a case for using local country’s marginal tax rate

World wide tax credit system: The home country recognizes taxes paid in a foreign country as a credit again tax liability at home. Analysts argue that one should sue the higher of the buyer’s or target’s country rate

Correct analysis would dictate determining the type of tax system to which the shareholders of the parent are subject to

What is India part of?

TIMING OF REMITTANCES OF CASH Countries limit the outbound movement of

cash and capital Costs to manufacture are incurred in one

country and revenues are realized in other countries (limits mobility of cash)

Such limitations sacrifice capital mobility of corporations

Firms can use financial intermediaries to synthesize a repatriation of cash even though a formal transfer has not occurred

Base case assumption ignore the timing of remittances of cash

ACCOUNTING PRINCIPLESAccounting principles differ across various

countries. These include treatment of CashExpense and investment recognitionPension accountingInflation accounting

Since DCF focuses on cash rather than accrued earnings, those national differences in accounting are not meaningful

However, the process of deriving cashflows from financial statements requires familiarity with accounting principles of foreign country

POLITICAL RISK Extent to which local governments intervene in the working

of markets can have a material effect on the value of corporate assets

Political risk can affect through regulation, punitive tax policies, restrictions on cash transfers, employment policies

Various estimates of political risk are available through different sources such Euromoney country risk rating, EIU Risk rating, International country risk guide, Institutional investor country risk rating, etc

They do not agree completely. Political risk is intangible and measured imperfectly

Two ways to adjust the valuation approach to political risk Adjust the cash flows of the target firm – Give a haircut Adjust the discount rate for the target firm’s cash flows –

differences in yields of government denominated in the same currency

SEGMENTED MARKETS Interest rates and equity market multiples

can vary substantially Inflation and currency effects Degree of integration of local financial

markets with global financial markets A local market is segmented when

financial assets command a different price there than in global markets Arises from barriers to trade that prevent

arbitrage Segmentation affects the discount rate,

the M&A analyst will choose

STRATEGY FOR DCF APPROACH

Rupee Denominated Cash flows

Rupee Denominated NPV

U.S. Dollar denominated Cash flows

U.S. Dollar denominated NPV

Approach A

Approach B

COMPARISON OF DCF APPROACHES

Approach A Approach B

Key features or key bets •Purchasing Power parity (PPP) and interest rate parity (IRP) hold•Inflation forecasts in foreign and home currencies are appropriate•Foreign country political risk premium is appropriate

•Quality of foreign capital market data is good•Local capital costs are free market yields

Strengths •Information environment•Can use high quality capital market information from developed countries

•Simplicity•Translation at spot foreign exchange rates

Weaknesses •PPP and IRD do not hold in all markets at all times•Long term inflation forecasts are unreliable

•Information environment is not strong in developing countries•Availability and quality of capital market data may be poor•Betas are not estimated for many stocks in emerging markets•Interest rates are administered by central banks and thus not reflect inflation

Choice between the two depends

on relative confidence in local capital market data

versus one’s relative confidence in the existence of

equilibrium between currency

and capital markets

ADJUSTING CASH FLOWS Need for internal consistency

Same tax rate should be assumed in estimating after tax cash flows, a levered beta and weighted average cost of capital and value of debt tax shields

The same inflation rate should be assumed in forecasting revenues, costs, additions to working capital and foreign currency exchange rates

Valuing real versus nominal cash flows Value nominal cash flows at nominal discount rates – most

prevalent Value real cash flows at real discount rates – used in high inflation

environments In theory, if cash flows and discount rates are internally consistent,

markets will value an asset the same under either approach Depreciation is a deductible expense for tax purposes. Depreciation

expense is tied to historical cost of the firm not the current (inflation adjusted) value

Firms will not deduct depreciation expense as inflation rises. As a result firms overpay taxes

TRANSLATING FOREIGN CURRENCY CASH FLOWS INTO HOME CURRENCY Requires forward exchange rates

beyond few years. Markets for most currencies do not offer exchange rates beyond three years

FWDRupee / Dollar = SPOTRupee / dollar (1+infRupee)n / (1+infdollar)n

Strong confidence in forecast of inflation rate for home and foreign currencies

Parity prevails in global currency and capital markets i.e., no segmentation

FACTORS AFFECTING THE DISCOUNT RATE FOR FOREIGN CASH FLOWS Estimate a cost of equity consistent with

the risk of the foreign target Estimate risk based on target’s stock

prices or prices of comparable firms Check for market segmentation and

require compensation for itTarget country is integrated

Target country is segmented

Foreign Capital Market information environment is strong

CAPM, ICAPMMultifactor model

Multifactor modelCredit ModelAdjusted CAPM

Foreign Capital Market information environment is weak

CAPM Adjusted CAPMCredit Model

ADJUSTING THE DISCOUNT RATE FOR CASH FLOWS Multifactor model

World stock market price risk Country stock market price risk Industry price risk Exchange rate risk Political risk Liquidity risk

(Ri-Rf)=∏+ßilW(RW -Rf)+ßilC(RC -Rf)+ßilI(RI -Rf)+ßEx(REx-Rf)+ßD(RD

C –RAAA)+ßL(RLoL -RHi

L)+errorWhere R=Return; Beta=Regression Coefficient; i=specific

company, f=risk free return; W=Global Equity market portfolio; C=Country equity market portfolio; I=Industry equity market portfolio; Ex=Portfolio of foreign currency deposits; D=Soverign debt instrument of the company’s home country (C); AAA=Highest rated sovereign debt instrument; L= Portfolio of low or high liquidity bonds

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