Advanced Valuation Issues
EV Calculation : Intrinsic Value vs Market Value www.finaticsonline.com
What does it mean?
Many believe that Enterprise Value calculation in DCF is unrelated to Relative or Comparable Valuation. The process of calculation is
in fact perfectly linked! This is particularly useful when handling anomalies or tricky items. The explanation below aims to decode the
link between the two approaches! This may be used as ‘How-to’ guide on item treatment in each approach.
EV Calculation under the DCF Approach EV Calculation when using Comparables
Step 1 ‒ Calculate & Discount Step 1 ‒ Get Diluted Market Value of Equity
i. Free Cash Flows
ii. Continuing/Terminal Value Step 2 ‒ Add :Debt & Other Forms of Capital at
Market Value (if unlisted, derive Fair value!)
= Enterprise Value
Step 3 ‒ Less: Non Operating Assets (Often called
Step 2 ‒ Less: Non equity Claims (at Fair Value) Cash & Cash Equivalents)
i. Debt (at Book Value or Fair Value, if traded!)
ii. Hybrid Capital (Preference Capital & FCCBs)
iii. Contingent Liabilities Rationale
iv. Restructuring provisions
EV calculation, under a ‘Market based’ approach is a
v. Pension & retirement related liabilities/deficits
mirror image of the Enterprise DCF approach!
vi. Capital & Capitalized Leases
Secondly, ‘Fair Value’ as defined by DCF, measures
vii. Minority Interest (at Market Value!)
‘Intrinsic Value’ of the firm based on future
Step3 ‒ Add: Non Operating Assets ‘fundamental’ performance of the firm.
i. Excess Cash (at Fair Value) While ‘Fair Value’ under Comparables approach
ii. Short term Investments (at Fair Value) starts with the presumption that the ‘Market is
right’ in determining Fair Value and hence starts
Add: Investment in Associates (at Fair/Market Value!) with ‘Market Value’ itself, only to test it later
through a peer comparison!
= Equity Value (Intrinsic/Fair Value of Equity)
Advanced Valuation Issues
EV Calculation : What should EV include? www.finaticsonline.com
Should Enterprise Value include Excess Cash, Marketable Securities and Investment in Associates?
It is popularly believed that Enterprise Value should not include these items. However, they must be included in Equity Value.
However, Equity is a part of the Enterprise and hence such items are a part of the Enterprise Value as well!
EV should include Excess Cash Explanation Analysis
Under the Mckinsey DCF Approach, ‘Step 1’ i.e. Q. If Cash is paid out as part of EV wont you get it Excess Cash belongs to Equity
Present Value of Free Cash Flows from explicit back ? Is cash a part of ‘Value’ ? holders. As Excess cash is,
forecast period + Present Value of Continuing value A. It is Excess Cash and not cash, that we are what remains after making
(Terminal Value) = Value of Operations talking about. Cash has two components a) payments to all other claim-
Where, Value of Operations ≠ Enterprise Value.
Operating & b) Excess. Operating Cash must be holders! In times of profits
Enterprise Value = Value of Operations + Excess Cash
& other non-operating assets accounted for in Operating working capital however, if such Cash is not
(incorporated in FCF itself!). ‘stored’ the company may have
The approach suggests, only after Excess Cash & Suppose, the company had no plans for such a liquidity crisis in bad times, or
Marketable Securities are added, is the true Value scenarios. Why didn't it pay out all of it as may have to raise extra funds
of the Firm/Enterprise revealed! Else the value of dividends? (at higher costs) for expansion
the firm is based on Operating activities alone and The Excess Cash may have been kept aside for a or diversification needs
will hence, always remain undervalued! ‘rainy day’ to be used in times of a liquidity crisis, Investors, will reward those
To prove the point, several leading companies with or for expansion or diversification needs. companies that use Excess
Excess Cash like Hero Honda, Infosys, Hindustan A buyer simply cannot ‘strip’ the Balance Sheet Cash ‘Well’, thereby increasing
Unilever etc. have ‘Created Value’ from non- of Excess Cash (while it is done in some LBO the Market Value.
operating assets as well! transactions!), if the buyer were to strip it of Basically, Excess Cash, Profit
cash, it would have to pump in the same amount from Investment in Associates
The same holds true for ‘Investments in eventually! etc. do create Value for Equity
Associates’ as well, it too creates value for (which in turn is a part of the
Shareholders and hence increases Value of Equity The ‘Negative EV’ phenomenon is a clear display of Enterprise). ‘Stripping’ a
which in turn increases Enterprise Value! a fallacy in the traditional EV concept as it does company of cash is a temporary
not reflect Acquisition Cost (the very reason why solution which will eventually
EV is calculated!) reverse!
Advanced Valuation Issues
EV Calculation : What should EV include? …Contd www.finaticsonline.com
Under the Enterprise DCF approach, while calculating Free Cash
Excess Cash, Marketable Flows and subsequently Terminal Value, Non –Operating items were
securities, Investment in deliberately excluded. This is because such items by nature, are
Associates and other assets
unrelated to the company’s operations and hence difficult to forecast.
whose Value has not been
captured in Free Cash Flow &
Hence, determining their Present Value is a fairly difficult task. They
Terminal value Calculation are hence added back to the Value of Operations on a book value
Secondly, the discount factor to determine present value of such
Equity Value Free Cash Flows should be the cost of generating them – The WACC.
The Weighted Average Cost of Capital is the ‘minimum expected
return’ of all capital contributors i.e. Debt, Equity, Hybrid etc. on a
weighted average basis). Implying that, WACC must also include the
cost of funding non-operating items.
Q. Usually, when non-operating items are significant it would be
worthwhile to value each such asset separately (often called SOTP).
Excess Cash, Marketable Securities & Instead, what if we could make a modification in the Free Cash Flow
calculation to include such items as well, would it yet be consistent
Investment in Associates “Add Value” to with the principles of the Enterprise DCF approach?
A. Absolutely! As WACC anyway includes cost of all funding sources
Equity, which in turn is a part of Enterprise irrespective of whether they are deployed in operating or non-
Value. Hence such items should be a part of Q. Now, wouldn't the EV include Excess Cash & non-operating assets?
Enterprise Value! A. Yes, of course!
Advanced Valuation Issues
EV Calculation : Bottom-Line www.finaticsonline.com
Approach 1: Popular Approach Illustration Approach 2: Mckinsey Approach Illustration
Step 1 ‒ Calculate & Discount Step 1 Step 1 ‒ Calculate & Discount Step 1
i. Free Cash Flows i. Rs.1,000Crs i. Free Cash Flows i. Rs.1,000Crs
ii. Continuing/Terminal Value ii. Rs. 2,000Crs ii. Continuing/Terminal Value ii. Rs. 2,000Crs
= Enterprise Value = Rs.3,000Crs = Operating Value = Rs.3,000Crs
Step 2 ‒ Less: Step 2 ‒ Less: Step 2 ‒ Add: Step 2 ‒ Less:
Non Equity Claims1 (Rs.1,500Crs) net of Cash & (Rs.1500- Rs.500) Excess Cash, Excess Marketable Securities & (Rs.1500+Rs.500)
Cash Equivalents (Rs.500Crs) =1,000Crs Investment in Associates = Rs.2,000Crs
Step 3 ‒ Add: Step 3 ‒ Add: = Enterprise Value = Rs.5,000Crs
Investment in Associates Rs.1,500Crs
Step 3 ‒ Less: Step 2 ‒ Less:
= Equity Value (Intrinsic/Fair Value of Equity) = Rs.3,500Crs Non Equity Claims1 (Rs.1,500Crs) Rs.1,500Crs
1Non Equity Claims include: Short term Debt, Long Term Debt, Preference Capital, FCCBs (& = Equity Value (Intrinsic/Fair Value of Equity) = Rs.3,500Crs
other convertible debt), Capital Lease, Capitalized Operating Lease, Restructuring Provisions,
Retirement related liabilities (deficits),Contingent Liabilities and Minority Interest.
The Seller’s Point of View Note
If Excess Cash & other Non-Operating items are not part of EV, the Although, both approaches result in the same Equity Value. The
Seller will simply refuse to part with them! However, the Buyer will ‘popular’ approach fails to recognize Excess Cash, Marketable
eventually replace them with his own funds, essentially increasing the Securities and Investment in Associates as a part of the Enterprise.
Value of the Enterprise by that much!! Resulting in an undervaluation of the Enterprise. It is for this reason
that we recommend the Mckinsey approach!
Equity Valuation Fundamentals
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