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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
THANK YOU
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
THANK YOU