Bottom up EV Calculation Finatics by alicejenny


									     Advanced Valuation Issues
     EV Calculation : Intrinsic Value vs Market Value                                                    

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?                                                                       

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                                               

                                                              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
                            Enterprise Value
                                                              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-
                                                              operating assets!
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                                                                                                       

 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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