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International Valuation Newsletter6th EditionFebruary 2018

In the first couple of weeks of 2018, the media’s attention has been seized by global stock market turmoil and the dramatic rise and fall of crypto currencies. Yet we must not lose sight of the fact that this follows capital markets staging an impressive rally in 2017. In this, our first edition of the International Valuation Newsletter of 2018, we look back at 2017 and present recent capital market data that are pertinent to any valuation analysis in these times of growing disruptions:

• Major stock market performances: Europe behind• EURO STOXX 600 sector multiples: Stable in Q4 2017• Current risk-free rates for major currencies: Stabilization of interest rates?• Recent country risk premiums and inflation forecasts for the BRIC countries:

Lowest for China (among the BRIC countries)

We also share our insights into the following topics that will be of use to any valuation practitioner:

• Fairness opinions for material business decisions• Valuing R&D projects in pharmaceuticals

As we progress in 2018 and face uncertainties that are as yet unknown, we look forward to discussing with you any questions you might have regarding valuation trends and practices.

Yours faithfully

Johannes PostPartner, Deal AdvisoryValuation / Financial ModellingEMEA Head of Valuation

Rolf LangeneggerDirector, Deal AdvisoryValuation / Financial Modelling

Dear reader

International Valuation Newsletter February 2018 3

Corporate transactions regularly involve fairness opinions to support decisions and protect decision-makers such as members of the board of directors or supervisory board. While fairness opinions generally focus on the evaluation of transaction prices in private or public M&A transactions, they can be used in much broader contexts, encompassing all material business decisions.

We live in an age when supervisory boards and active shareholders play an increasing role in challenging corporate decisions. And when decision-makers can face personal liability if they are found to be negligent in their due diligence obligations. Effective protection in the form of fairness opinions is therefore growing in importance, especially to demonstrate that decision-makers have followed the so-called business judgment rule. A fairness opinion based on established principles and issued by an audit firm can be essential in documenting compliance with due diligence requirements.

The liability of executive board members and, to a lesser extent, supervisory board members is governed by local law. But it has been extended in many countries in recent years to the effect that corporate decision-makers must incorporate proper and conscientious due diligence into their daily work. They can avoid liability if, for the purpose of the business judgement rule, they have demonstrably acted in the best interests of the company by reaching business decisions based on comprehensive information.

The role of financial profitability in business decisionsKey is assessing financial profitability in business decisions. This is not limited to the transaction price when acquiring or disposing of shares or, more generally, to the amount of an investment or disinvestment. It is also relevant in financing decisions such as those relating to transactions, restructuring or refinancing. In essence, to all important business decisions, including:

• Should assets, business lines or further equity be sold to pay off loans due? Is equity financing through capital measures more favorable than debt financing? Is a shareholder loan more favorable than other sources of financing? How will a shareholder loan affect the rating?

• In the case of acquisitions, are financial resources of related companies and persons involved?

• How do changes in the business portfolio affect the entire company and what interdependencies (positive and negative synergy effects) can be expected in the event of portfolio changes?

• Should a production facility continue operating or should it be closed or sold?

• What are the financial implications of intended fundamental changes in the corporate strategy, for example as a result of changes in relevant sales or procurement markets? What strategic options does the company have and which strategy is the better alternative from a financial perspective?

• Is own development or acquisition of a particular technology (make or buy) less expensive?

• Should a settlement be concluded to end a legal proceeding, to avoid a long-term financial burden with incalculable litigation costs and risks and to free up tied management capacities?

It is a case of finding and documenting answers to concrete questions. Wrong decisions can prove expensive in the form of either direct expenses or opportunity costs. Key decisions must therefore be prepared thoroughly and backed up by comprehensive information. Comparing alternatives can be examined by means of comprehensible, adequate and individually determined assessment criteria for their financial consequences for the company.

Fairness opinions for material business decisions


The necessary tools to deliver the right resultThe basic tools are a financial controlling system that generates comprehensive information, an integrated and multi-year financial plan, and an appropriate method of capital budgeting and business valuation. The result should be a financial profitability analysis that is thoroughly substantiated and summarized in professional fairness opinions.

An issue that continues to grow in importanceAs corporate transactions continue to be driven by a range of factors such as growing momentum in the M&A market, new technologies and business models, and increased competition, many companies have faced the consequences of overpaying for their acquisitions. Corporate risk awareness has grown accordingly. Fairness opinions are a sensible, consistent and necessary way of applying an independent third party’s knowledge of a transaction’s financial aspects. For corporate decision-makers, the product is a fairness opinion that is vital to securing legal protection and – most crucially – the right outcome for the business.


R&D projects to develop new drugs routinely face challenges and uncertainties. Pharmaceutical companies must often decide whether to invest further in the project, choose to pursue it in the form of a strategic alliance, or even to abandon the project. A robust financial valuation of the R&D project is critical to informing this decision. And financial analysis is an important tool in communicating the project value or increase in value investors can expect as key milestones are successfully reached. A regular, thorough and documented valuation of R&D projects is therefore essential.

Valuing R&D projects in pharmaceuticals

The uncertain outcomes of an R&D processIn the pharmaceutical industry, the R&D process for a particular project can often cover a period of 10 to 12 years, from identifying suitable molecular structures, through preclinical and clinical development to regulatory approval and market launch. The preclinical and clinical development can itself last up to seven years. This entire process involves an extremely high level of personnel time and capital resources. In addition, developing the dosage form – an important part of the development process – requires investment in production facilities.

In order to obtain approval for the new drug, the end of the R&D process involves documenting the efficacy of the active ingredient and its safety and quality in accordance with a range of regulatory requirements. In reality, only a very small proportion of drug candidates achieve this goal. Most projects are terminated during the course of development due to technical or economic reasons. A very small number of approved drugs reach the status of ‘blockbuster’ and achieve the economic success needed to finance fresh investments in the research and development of new active ingredients.

Financial valuation as a monitoring and decision-making toolThe financial loss in the event of a drug candidate’s failure is usually substantial. It can amount up to EUR 1 billion for active substances that have reached an advanced stage of development. It is therefore necessary to assess at regular intervals during development whether funding and development of the drug candidate should be continued.

The starting point for the financial assessment is to value the R&D project in its current state of development. The valuation is carried out by determining a net present value, taking into account the uncertainties of a successful development process in the form of probability-weighted future cash flows. Key value drivers for the pharmaceutical company are also identified. The risk/return analysis is of great importance. In addition to the qualitative assessment, the results form the basis of the entrepreneurial decision whether or not to further invest in the drug candidate.

Selection of relevant projects

Risk/Return determination of each project by Monto-Carlo simulation

Defining criteria and sub-conditions

Evaluation of optionsImplementation Partnership Termination auf nächste Zeile

1 2 3 4

Sub-conditions• Budget• Time • Resources• Vision

Criteria• NPV• IRR/ROI• Risk• Strategic fit

Source: KPMG


Assessing the strategic optionsIn light of the financial risks to the pharmaceutical company, a number of options are increasingly being pursued. These include strategic research or sales alliances, in-licensing and out-licensing, and suitable business combination forms. A strategic alliance allows the yield expectations of the drug candidate to be shared while significantly reducing the financial risks. The likelihood of market approval is also often increased by bundling research expertise with the strategic partner, or out of the synergy potential that arises from combining distribution networks.

The starting point for assessing the economic attractiveness of an alliance is to derive the net present value of the R&D project. A comparison can then be made between the value contribution of the given and received considerations. In this context, the present value of upfront and milestone payments made by the alliance partner is compared with the present value of the expected future cash flows to which the alliance partner is entitled.

The pressure to innovate to develop new active ingredients is considerable. Some companies will conduct these activities in-house. But increasingly, this pressure is leading to R&D projects being set up as either an asset deal (e.g. by purchasing a drug candidate) or a share deal (e.g. by purchasing an entire company). For this purpose, the financial assessment is a central basis for strategic decision-making and for the subsequent balance sheet presentation in the context of stand-alone and consolidated financial statements.

Financial valuation of drug candidatesThe prevailing valuation methodology for R&D projects in practice is based on the discounted cash flow method and takes into account cash inflows and outflows over the entire product lifecycle of the drug candidate – i.e. up to the patent expiration date or a subsequent generic phase. To derive the net present value, the periodic surpluses or losses with risk equivalent capital costs are discounted to the valuation date.

When developing new drug candidates, the risk of negative development results and the cost of further necessary investments is of great importance. Valuation models must take into account the uncertainties of the results of preclinical and clinical studies. This can be done by applying decision trees to the regular, methodical planning of the different development phases up to market approval. These decision trees also take into account the decision dates and milestones in which new essential medical-technical results such as study results are expected and subsequent investment decisions are linked. The successful or unsuccessful completion of the planned milestones is based on probabilities, with the planned future cash flows reflected in the financial valuation accordingly. Given the individual nature of each drug candidate, the key challenge is to forecast the expected probabilities, which can vary widely depending on the specific indication area. Company-specific empirical values and public information, in particular assessment by project experts, form the basis for a range of probabilities rather than an exact probability value.

Decision for project start 30%

50%

70%

80%

70%

50%

30%

20%

Success

Success

Success

Success

20% NPV: EUR 250 Mio



ExpensesEUR 2 Mio

ExpensesEUR 6 Mio

ExpensesEUR 5 Mio

Approval costsEUR 1 Mio

Termination

Termination

Termination

Termination

Expenses

Phase IPhase IIPhase IIIApproval

EUR 2,0EUR 1,8EUR 0,8EUR 0,1

EUR 2EUR 6 x 0,3EUR 5 x 0,3 x 0,5EUR 1 x 0,3 x 0,5 x 0,7

Sum EUR 4,7

E(X) EUR 8,8

Project (EUR Mio)

Scenario E(X)

HighMediumLow

EUR 4,2EUR 7,6EUR 1,7

EUR 250 x 0,3 x 0,5 x 0,7 x 0,8 x 0,2EUR 150 x 0,3 x 0,5 x 0,7 x 0,8 x 0,6EUR 100 x 0,3 x 0,5 x 0,7 x 0,8 x 0,2

Sum EUR 13,4


Before seeking approval of the drug, a company will have forecast its commercial progress. For this purpose, sales and cost trends must be planned for the respective approval regions. Compared to very early-stage R&D projects, planning uncertainties decline as the stages of development progress. This is due to the fact that the properties of the drug candidate become increasingly known and a more precise prediction can be made based on the medical need or number of patients, competitive situation and health policy environment (and thus the price modalities in the target regions). Nevertheless, the result can be a forecast range for the key value drivers such as patient penetration, market share and price development during the commercialization phase. When planning cost developments, the primary focus is on research costs, marketing expenses and production costs. While the research costs are highly dependent on the indication area and the treatment of the test persons, the inclusion of the own distribution network or the necessary use of a sales partner is an important planning premise.

The consideration of specific scenarios with the aid of decision trees illustrates a possible range of values for the specific R&D project, in the form of individual valuation results for each scenario. Due to the high degree of sensitivity and uncertainty of the key planning premises, it is worth linking the valuation model with a Monte Carlo simulation. For this purpose, suitable estimation ranges and probability distributions (e.g. triangular and PERT distributions) must be defined for the individual value drivers to simulate the combination. A Monte Carlo simulation then depicts the effects of all defined uncertainties and answers the question of the probability and premises under which valuation results can be achieved. Determining the minimum, mean and maximum values across the range of simulations, the analysis offers further important reference points for the R&D project’s value range. In addition, it can enable insights regarding which planning premises have significant or insignificant influences on the valuation result.

In connection with the qualitative assessment of the development project, the financial valuation provides a fundamental basis for future investment decisions regarding the project in question, as well as feeding into decisions regarding other, or future, projects. Also for the development of the portfolio's performance by deriving reliable value ranges and financial indicators. This is of strategic importance not only for management but also for target-oriented communication with investors and capital markets.


In this, we provide a selection of key financial market data, covering:• Comparison of major stock market performances for the

12 months ending 30 December 2017• EURO STOXX 600 sector multiples• Risk-free rates for major currencies• Country risk premiums and inflation forecasts for the

BRIC countries

Major stock market performances: Europe behindStock markets performed remarkably well throughout 2017, with leading indices even seeing double-digit growth rates amid a global stock rally. European stock indices lagged clearly behind their counterparts in other parts of the world, however. In 2017, outstanding performances were noted from the MSCI Emerging Markets Index (+34.3 percent),

NASDAQ Index (+28.2 percent), the MSCI World Index (+20.1 percent), the S&P 500 Index (+19.4 percent) and the Nikkei 225 Index (+19.1 percent).

The Nikkei 225 Index outperformed its peers with a growth rate of 11.8 percent on a quarterly basis (in Q4 2017), followed by MSCI Emerging Markets Index’s growth of 7.1 percent in the same quarter. The two major indices that performed negatively in Q4 2017 were the Ibex 35 Index at minus 3.3 percent and the CAC 40 Index at minus 0.3 percent – although both indices performed positively in 2017 overall. The FTSE 100 gained momentum despite the ongoing Brexit negotiations and increased in Q4 by 4.3 percent compared to an increase of 0.8 percent in Q3..

Capital market data

Performance of leading indices31 December 2016 – 31 December 2017

5.1%7.1%

0.3%

4.3%

0.7%

(0.3)%(3.3)%

2.5%

6.1% 6.3%

11.8%

20.1%

34.3%

7.7% 7.6%

12.5%

9.3%7.4%

14.1%

19.4%

28.2%

19.1%

MSCI World MSCIEmergingMarkets

STOXX Europe

600

FTSE 100 DAX CAC 40 Ibex 35 SMI S&P 500 NASDAQ Nikkei 225

Inde

x pe

rfor

man

ce (%

)

QoQ YoY

Source: Capital IQ, KPMG analysis


EURO STOXX 600 sector multiples: Stable in Q4 2017The enterprise value (EV) multiple states the market value of the business in relation to an appropriate base metric. Commonly used EV multiples are revenue and EBITDA. The numerator (EV) and denominator (Revenue, EBITDA) represent all investor claims on the business.

The Euro STOXX 600 sector overview of trading multiples showed no significant outliers or other extremes based on EV/revenue and EV/EBITDA in Q4 2017 compared to Q3 2017. Only the energy (oil and gas) sector moved noticeably in 2017, when the EV/EBITDA multiple fell from 9.2x in Q1 to 7.1x in Q2 and then rose again to 7.9x in Q4.

1.8x 1.7x 1.7x 1.8x

11.1x 10.8x 10.7x 10.2x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

EV/Revenue EV/EBITDA

Consumer Discretionary Median

Energy (Oil and Gas) Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

1.2x 1.0x 1.1x 1.3x

9.2x7.1x 7.6x 7.9x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


Healthcare Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

3.5x 3.7x 3.6x 3.6x

15.2x 16.1x 15.5x 14.8x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


2.1x 2.2x 2.2x 2.2x

12.9x 13.3x 13.1x 12.7x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


Consumer Staples Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

Financials Median1

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

1.3x 1.4x1.7x 1.8x

1.1x 1.2x 1.2x 1.2x

0.0x

1.0x

2.0x

3.0x

EV/Revenue P/BV

Industrials Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

1.5x 1.5x 1.6x 1.6x

11.9x 11.9x 12.3x 11.8x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x



Information Technology Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

4.6x 4.5x 4.4x 4.2x

15.5x 15.8x 16.0x17.1x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


Telecommunication Services Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

2.4x 2.2x 2.3x 2.3x

8.4x 8.4x 8.8x 8.6x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


Materials Median

31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

1.8x 1.6x 1.7x 1.7x

9.7x 9.6x 10.0x 9.8x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


31Mar17

30Jun17

30Sep17

31Dec17

31Mar17

30Jun17

30Sep17

31Dec17

1.8x 1.6x 1.6x 1.6x

9.6x 9.9x 9.6x 9.9x

0.0x

3.0x

6.0x

9.0x

12.0x

15.0x

18.0x


Utilities Median

Risk-free rates: Stabilization of interest rates?The risk-free rate (or base rate) can generally be broken down into two key components that seek to compensate the investor: the first for expected inflation and the second for deferred consumption. The base rate is considered to be free of risks except for risks embedded in the underlying currency and risks related to investments in the particular country (including general political, legal, regulatory and tax risks, as well as the risk of a moratorium). As no investment is truly risk-free, the risk-free rate is typically approximated

by reference to the yield on long-term debt instruments issued by presumably financially healthy governments. The historical risk-free rates for Germany, the Eurozone, the US, the UK and Switzerland are below.

There was a slight downward movement in Q4 2017 compared to the previous quarter in the risk-free rates for Germany, the Eurozone, the US, the UK and Switzerland. Between the end of 2016 and the end of 2017, noticeable increases in the risk-free rates took place only for Eurozone countries.

Risk-free rates

Rounded Euro-countries Germany UK Switzerland USADate EUR EUR GBP CHF USD

31/3/201330/6/201330/9/201331/12/2013

2.50%2.74%2.71%2.88%

2.24%2.51%2.62%2.81%

3.23%3.60%3.57%3.72%

1.34%1.60%1.74%1.93%

3.17%3.56%3.81%4.06%

31/3/201430/6/201430/9/201431/12/2014

2.53%2.28%1.92%1.46%

2.51%2.26%1.97%1.56%

3.58%3.49%3.12%2.58%

1.65%1.56%1.28%0.80%

3.67%3.44%3.30%2.85%

31/3/201530/6/201530/9/201531/12/2015

0.69%1.79%1.51%1.70%

0.70%1.65%1.38%1.55%

2.39%2.80%2.58%2.77%

0.43%0.79%0.81%0.70%

2.66%3.31%3.06%3.17%

31/3/201630/6/201630/9/201631/12/2016

1.03%0.46%0.53%0.97%

0.90%0.49%0.47%0.95%

2.39%1.85%1.61%2.03%

0.25%(0.03)%(0.06)%0.35%

2.81%2.50%2.48%3.06%

31/03/201730/06/201730/09/201731/12/2017

1.25%1.39%1.40%1.34%

1.24%1.33%1.38%1.34%

1.88%2.02%2.05%1.89%

0.32%0.39%0.45%0.36%

3.27%3.04%3.04%2.89%

Source: KPMG analysis; Approach: determination of a present value-equivalent uniform interest rate based on the yield curve of the specific central bank

Source: Capital IQ, KPMG analysisNote: 1 Financial services companies differ from many other companies in how they operate. Debt acts more like ‘raw material’ than operational capital for financial services companies. A common valuation metric used by analysts evaluating such firms is the price to book (P/B) ratio.


Country risk premium: Lowest for China (among the BRIC countries)The country risk premium is a measure of risk faced by businesses when investing in sovereign states. It reflects a number of risks including economic, financial, political and institutional. The country risk premium is effectively the risk of low probability, high impact events that could lead to significant losses in investment values. These types of risk are at the forefront of many investors’ thinking now more than ever due to a number of major economic and geopolitical events such as the Eurozone sovereign debt crisis and events in the Middle East and North Africa, all of which have led to previously stable countries becoming

much riskier. KPMG’s Valuation practice has been analyzing and measuring country risk for 15 years and covers more than 150 sovereign states in a proprietary KPMG analyst model.

The country risk premiums for Brazil, Russia, India and China are set out below as of 31 December 2017 for an investment period of between 0.5 and 2 years. The country risk premium for China is substantially lower than that for Brazil, Russia or India. The high country risk premium for Brazil is driven chiefly by political and institutional uncertainties over various investment horizons.

Growth ratesGrowth rates are a major component of the terminal value calculation for the discounted value method and are based on country-specific inflation forecasts. The growth rates for Brazil, Russia, India and China are based on the International Monetary Fund Economist Intelligence Unit inflation forecast for the years 2018 to 2022.

High growth rates are expected for Brazil, Russia and India in 2018, and stable growth over the long term. A more moderate growth rate development is expected for China in 2018 and from 2019 onwards.

Country risk premium 0.5 year 1.0 year 2.0 year

Brazil 2.2% 2.4% 3.0%

Russia 1.7% 1.8% 2.3%

India 1.6% 1.8% 2.1%

China 0.9% 1.0% 1.0%

Inflation forecast 2018 2019 2020 2021 2022

Brazil 4.0% 4.1% 4.1% 4.0% 4.0%

Russia 3.9% 4.0% 4.0% 4.0% 4.0%

India 4.9% 4.8% 4.9% 5.0% 5.0%

China 2.4% 2.5% 2.6% 2.6% 2.6%

Source: KPMG CRP study

Source: IMF

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received, or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. The scope of any potential collaboration with audit clients is defined by regulatory requirements governing auditor independence. © 2018 KPMG AG is a subsidiary of KPMG Holding AG, which is a member of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss legal entity. All rights reserved.

Contacts

KPMG AGBadenerstrasse 172PO BoxCH-8036 Zurich

kpmg.ch/dealadvisory

Johannes PostPartner, Deal AdvisoryEMEA Head of Valuation

+41 58 249 35 [email protected]

Rolf LangeneggerDirector, Deal Advisory Valuation / Financial Modelling

+41 58 249 42 [email protected]

Documents

international Valuation Newsletter - Kpmg · that are pertinent to any valuation analysis in these times of growing ... budgeting and business valuation. ... International Valuation