Valuation
Rs.
Anjana Vivek www.venturebean.com beanie@venturebean.com
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FOREWORD
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How does one value a company? While at a broad level one may be able to understand why a company may be worth a certain amount to an investor or a buyer, it is not always possible to understand why someone is willing to pay a certain amount for a business.
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FOREWORD
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A business worth a significant amount at a certain point in time may suddenly lose much of its value a very short while later.
This is what happened in many companies commonly referred to as ‘dot-com companies,’ which were valued at amounts which may seem absurd now…. in hindsight. 3
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AGENDA
Topic Background Slide no. 6
Valuation methods
Cost based Book value Goodwill
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16 18 24
Intangible assets
Replacement Liquidation Income based Earnings capitalisation DCF Limitations of DCF Market based
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31 32 33 35 36 43 52 4
AGENDA
Topic What value depends on Valuation process Special situations Multi business M&A 75 84 Slide no. 63 67
Cyclic companies
Companies in distress Cross border transactions Privatisation
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94 97 102
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BACKGROUND - FAQs
Why do values of companies change from time to time? Does value depend on whether one wants to sell a company, to buy a minority stake or to buy the entire company? Will a strategic investor value a company differently from a financial investor? How can a company which is continually losing money have any value?
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VALUATION PROCESS
Review and selection of the methods of valuation Understanding of issues which impact valuation Special situations and their impact on valuation
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What is value
Cost vs. Market Value
Historical vs. Replacement Differs depending on need of person doing valuation – buyer, seller, employee, banker, insurance company
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Value to user
Valued because of expected return on investment over some period of time; i.e. valued because of the future expectation
Return may be in cash or in kind
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Complex nature of valuation
Value A + Value B can be
greater or less than Value (A+B)
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Why Value
When do you think a company is to be valued?
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Why Value
To Purchase Sell Transact Take decisions Report
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VALUATION METHODS
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Valuation methods
These can be broadly classified into:
Cost based Income based Market based
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Valuation methods
Different experts have different classifications of the various methods of valuation Within these methods, there are sub-methods Sometimes the methods overlap
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1. COST BASED METHODS
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Cost based methods
Book value
Replacement value
Liquidation value
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Book value method
Historical cost valuation All assets are taken at historical book value Value of goodwill* is added to this above figure to arrive at the valuation
*We will see how goodwill is valued in later 18 slides
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Book value method
Historical cost valuation All assets are taken at historical book value Value of goodwill is added to this above figure to arrive at the valuation
Do you think there would be any difficulties in this?
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Book value method
Current cost valuation All assets are taken at current value and summed to arrive at value This includes tangible assets, intangible assets, investments, stock, receivables
VALUE = ASSETS - LIABILITIES
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Book value method
Current cost valuation All assets are taken at current value and summed to arrive at value This includes tangible assets, intangible assets, investments, stock, receivables
What do you think could be difficulties in this method?
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Book value method
Current cost valuation: Difficulties
Technology valuation – whether off or on balance sheet Tangible assets – valuation of fixed assets in use may not be a straightforward or easy exercise Could be subject to measurement error 22
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Book value method
Current cost valuation: More difficulties
The company is not a simple sum of stand alone elements in the balance sheet Organisation capital is difficult to capture in a number – this includes
– – – – Employees Customer relationships Industry standing and network capital Etc…
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Valuation of goodwill
Based on capital employed and expected profits vs. actual profits Based on number of years of super profits expected May be discounted at suitable rate
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Valuation of goodwill
Normal capitalisation method
– Normal capital required to get actual return less actual capital employed
Super profit method
– Excess of actual profit over normal profit multiplied by number of years super profits are expected to continue
Annuity method
– Discounted super profit at a suitable rate
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Valuation of goodwill
COMPANY A Capital employed: Rs. 45 cr Normal rate of return: 12 % Future maintainable profit: Rs. 5.5 cr
What would be the goodwill under the normal capitalization method? SOLUTION: (change font colour to see this) = (5.5/.12) – 45 = Rs. 0.83 cr
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Valuation of goodwill
COMPANY B Capital employed: Rs. 50 cr Normal rate of return: 15 % Future maintainable profit: Rs. 8 cr Super profit can be maintained for:3 years What would be the goodwill under the super profit method? SOLUTION: (change font colour to see this) = [8 – (50*.15) ] * 3 = Rs.1.50 cr 27
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Valuation of IA
The value of the IA is from Economic benefit provided Specific to business or usage Has different aspects
– Accounting value – Economic value – Technical value – Can you think of examples of these different values?
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Valuation of IA
Depends on objective and can vary widely depending on purpose For accounting purposes – to show in financial statements For acquisition/merger/investment For management to understand value of company for decision making
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IA value in transactions
Often value paid in M&A deals is more than market value/book value. This could be: Partly due to over bidding due to strategic reason (existing or perceived) and Partly due to IA of company, not captured in balance sheet
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Replacement value method
Cost of replacing existing business is taken as the value of the business
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Liquidation value method
Value if company is not a going concern Based on net assets or piecemeal value of net assets
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INCOME BASED METHODS
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Income Based methods
Earnings capitalisation method or profit earning capacity value method Discounted cash flow method (DCF)
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Earnings capitalisation method
This method is also known as the Profit earnings capacity value (PECV) Company’s value is determined by capitalising its earnings at a rate considered suitable Assumption is that the future earnings potential of the company is the underlying value driver of the business Suitable for fairly established business having predictable revenue and cost models 35
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Discounted cash flow method
Creame Corner wants to acquire Samosa Specials for Rs. 10 million. The net cash flows are in the table below. Creame Corner wants to apply a discount rate of 15%. Should it buy Samosa Specials?
Year
Net CF Rs. ‘000
15% disc.
1 2 3 4 5
-10,000 1,000 3,000 5,000 6,500
1 0.8696 0.7561 0.6575 0.5718
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Discounted cash flow method
NPV is positive hence based on this method, the answer is YES, the acquisition should be made!
Can you think of three deficiencies in this valuation method?
Year
Net CF
Rs. ‘000
15% NPV disc. Rs. ‘000
1
2 3
-10,000
1,000 3,000
1
0.8696 0.7561
-10,000
870 2,268
4
5
5,000
6,500 5,500
0.6575
0.5718
3,288
3,717 142
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Applicability of DCF method
Cash flow to equity
– Discount rate reflects cost of equity
Cash flow to firm
– Discount rate reflects weighted average cost of capital
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Discounted cash flow
Cash flow to equity
– Valuation of equity stake in business – Based on expected cash flows – Net of all outflows, including tax, interest and principal payments, reinvestment needs
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Discounted cash flow
Cash flow to firm
– Value of firm for all claim holders, includes equity investors and lenders – Net of tax but prior to debt payments – Measures free cash flow to firm before all financing costs
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Discounted cash flow
CFt Value t t 1 (1 r )
• CF is cash flow • t is the year and • r the discount rate
t n
i.e. the cash flow for each year from year 1 to year n (which is the time period under consideration) is discounted to arrive at the present value of future cash flows from year 1 to n
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Applicability
Discounted cash flow is based on expected cash flow and discount rates Sometimes it is difficult to get a reliable estimate for the future and the valuation model may need modification
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Limitations
Companies in difficulty
– Negative earnings – May expect to lose money for some time in future – Possibility of bankruptcy – May have to consider cash flows after they turn negative or use alternate means
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Limitations
Companies with cyclic business
– May move with economy & rise during boom & fall in recession – Cash flow may get smoothed over time – Analyst has to carefully study company with a view on the general economic trends. The bias of the analyst regarding the economic scenario may find its way into the valuation model
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Limitations
Unutilised assets of business
– Cash flow reflects assets utilised by company – Unutilised and underutilised assets may not get reflected in the valuation model – This may be overcome by adding value of unutilised assets to cash flow. The value again may be on assumption of asset utilisation or market value or a combination of these
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Limitations
Companies with patents or product options
– Unutilised product options may not produce cash flow in near future, but may be valuable – This may be overcome by adding value of unutilised product using option pricing model or estimating possible cash flow or some similar method 46
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Limitations
Companies in process of restructuring
– May be selling or acquiring assets – May be restructuring capital or changing ownership structure – Difficult to understand impact on cash flow
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Limitations
Companies in process of restructuring
– Firm will be more risky, how can this be captured? – Historical data will not be of much help – Analysis should carefully try to consider impact of such change
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Limitations
Companies in process of M&A
– Estimation of synergy benefit in terms of cash flow may be difficult – Additional capex may be calculated based on inadequate information or limited data – Difficult to capture effect of change in management directly in cash flow – Analyst should try to study impact of M&A with due care
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Limitations
Companies in process of M&A
Historically, many M&As have not done as well as expected. Many times this has been attributed to valuation being too high. To minimise this risk of over valuation, a proper due diligence review (DDR) exercise is to be done, with one of the mandates for this being careful review of the value drivers and the business proposition.
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Limitations
Unlisted companies
– Difficult to estimate risk – Historical information may not be indicative of future, particularly in early stage, growth phases – Market information on similar companies can be difficult to obtain
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MARKET BASED METHOD
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Market based method
Also known as relative method Assumption is that other firms in industry are comparable to firm being valued Standard parameters used like earnings, profit, book value Adjustments made for variances from standard firms, these can be negative or positive
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Exercise in Valuation
Plantation Co. Enterprise market value/sales 1.4 Enterprise market value/EBITDA 17.0 Enterprise market value/free cash flows 20 Application to Meadows Co. Sales EBIDTA Free cash flow Garden Co. 1.1 15.0 26 Park Co. 1.1 19.0 26
Rs. 200 crores Rs. 14 crores Rs. 10 crores
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Value estimated
Plantation Co. Enterprise market value/sales 1.4 Enterprise market value/EBITDA 17.0 Enterprise market value/free cash flows 20.0 Application to Meadows Co. Sales EBIDTA Free cash flow Garden Co. 1.1 15.0 26.0 Park Co. 1.1 19.0 26.0 Average 1.2 17.0 24.0
Rs. 200 crores Rs. 14 crores Rs. 10 crores
Average Value 1.2 Rs. 240 crores 17.0 Rs. 238 crores 24.0 Rs. 240 crores
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Exercise in Valuation
Papers Co 2.6 10.0 21.0 Docs Co. 1.9 21.0 30.0 Prints Co. 0.9 4.0 24.0
Enterprise market value/sales Enterprise market value/EBITDA Enterprise market value/free cash flows Application to PenPencil Co. Sales EBIDTA Free cash flow
Rs. 300 crores Rs. 15 crores Rs. 7.5 crores
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Value estimated ?
Papers Co Enterprise market value/sales 2.6 Enterprise market value/EBITDA 10.0 Enterprise market value/free cash flows 21.0 Application to PenPencil Co. Sales EBIDTA Free cash flow Docs Co. 1.9 21.0 30.0 Prints Co. 0.9 4.0 24.0 Average 1.8 11.7 25.0
Since multiples differ, this cannot be used as a dependable guide for valuation 57
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Rs. 300 crores Rs. 15 crores Rs. 7.5 crores
Average Value 1.8 Rs. 540 crores 11.7 Rs. 175.5 crores 25.0 Rs. 187.5 crores
Relative Valuation
Using fundamentals
– Valuation related to fundamentals of business being valued
Using comparables
– Valuation is estimated by comparing business with a comparable fit
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Relative Valuation
Using fundamentals for multiples to be estimated for valuation
– Relates multiples to fundamentals of business being valued, eg earnings, profits – Similar to cash flow model, same information is required – Shows relationships between multiples and firm characteristics
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Relative Valuation
Using Comparables for estimation of firm value
– Review of comparable firms to estimate value – Definition of comparable can be difficult – May range from simple to complex analysis
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Applicability
Simple and easy to use Useful when data of comparable firms and assets are available
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Limitation
Easy to misuse Selection of comparable can be subjective Errors in comparable firms get factored into valuation model
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VALUATION: What it depends on
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Valuation depends on
Management team Historical performance Future projections Project, product, USP Industry scenario Country scenario Market, opportunity, growth expected, barriers to competition
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Valuation depends on
Nature of transaction Whether 1st round or later round Whether family and friends or other parties Amount of money required Stage of company - early stage, mezzanine stage (pre-IPO), later stage (IPO)
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Valuation depends on
Strategic requirements and need for transaction Demand / supply position Flavour of the season
Initial ballpark valuation can also be a deal issue
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VALUATION: Process
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Process of valuation
Consider Net assets tangible and intangible Financial data Historical information Company info Industry info Economic environment
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Process of valuation
Include elements of cash, costs, revenues, markets Plan long term not short haul Use more than one model Discount for risks, assign probabilities Arrive at range
A valuation range is preferable to a single number www.venturebean.com
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Process of valuation
Finally after arriving at the value range raise some fundamental questions
Does the value reflect the past performance and the expected future? Does the value reflect the USP as compared to competition? Does the value reflect the quality of the management?
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Process of valuation
The last mile…
Does the valuation reflect the picture you have of the business? Would you be willing to pay this price?
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Valuation: for investment
Valuation is perception in the eye of the beholder It is subject to negotiation
Investor Value Company Value
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Valuation: in M&A
Value of combined business is expected to be more than value of the individual companies
Value (A+B) Value A + Value B
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APPLICATION OF VALUATION MODELS
In special cases
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Multi business models
The entire business is valued as a sum of the parts Valuation depends on successful management of different units Strategic decisions usually occur at each business unit level To understand the company one needs to first understand the opportunities and threats faced by each business unit
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Multi business models
Valuation of company that is based on valuation of individual business units provides deeper insight Valuation of individual business units also helps understand whether the company is more valuable as a whole or in parts and to understand where the value is (eg. in some units or in the company as a whole)
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Multi business models
Particularly useful in restructuring and reworking business and financial strategy of the business going ahead Helps understand and get a better picture of costs of the corporate office and understand allocation of these costs and whether these can be reduced 77
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Multi business models
Identifying business units can be complex Cash flows projection can be complex and interdependent on different units Allocation of corporate office costs and other company costs/benefits may be difficult
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Multi business models
A business unit is identified as one which can be split off as a stand alone unit or sold to another enterprise
– Units are to be logically separable – They should not have depend production/sales/distribution etc. – Some joint products may fall under one unit, if there is interdependency which calls for this – If there is limited interdependency, this may be viewed by considering transfer pricing and whether transactions could be 79 considered ‘arms length’
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Multi business models
Allocation of corporate costs including some or all of these:
– Salary and other costs of key management – Board costs – Corporate administration costs – Costs of listing as a public company – Advertising and marketing costs
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Multi business models
Allocation methods are to be carefully thought through and could be a combination of different methods for different costs, including
– Based on time spent (time sheets) – Advertising based on revenue
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Multi business models
Benefits are also to be incorporated, including
– Saving on operational costs – Information/communications – Tax benefits / shields (ie one loss producing unit would provide a shield to another profit making one – important when one is considering a split up / hive off of some units) – Intangible benefits – can these be quantified? (Eg key person in management team / Board)
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Multi business models
Difficulties and concerns
– Partial holdings in units (taken as a percentage of ownership of business unit value) – Double counting may occur – Allocation may pose difficulties – Interdependency may not be easy to separate – Intangibles cannot be easily quantified – Transfer pricing to be viewed in the regulatory context
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Mergers/Acquisitions
These have become very important as companies try to grow inorganically or network to exploit possible synergies Most senior executives may be involved in such transactions
– Directly or indirectly – In the buy side or target side
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Mergers/Acquisitions
Rationale for the proposed transaction is to be understood Synergy
– Revenues – Costs – Intangibles
Control/ dominance in market Under valuation perceived (LBOs/LBIs)
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Mergers/Acquisitions
Studies show that generally acquired company shareholders gain Reasons for failure
– Poor post acquisition management – Over payment for target
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Mergers/Acquisitions
Research has suggested that the following factors have resulted in positive deals
– Bigger value creation overall – Lower premiums paid – Better run by acquirers
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Mergers/Acquisitions
Overpayment could be because of a combination of these factors: Market potential - overoptimistic appraisal Synergy – overestimated Due diligence – inadequate Bidding – excessive
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Mergers/Acquisitions
Synergy
– Operational (vertical and horizontal M&A eg backward integration, captive customer) – Functional (Production, sales) – Benefits (tax, control etc.) and impact on cash flow to be quantified (eg. increased sales, reduced wages) keeping timing in mind
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Mergers/Acquisitions
LBOs/LBIs Initially high leverage May be followed by rapid reduction in debt This impacts business risk which will change
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Cyclic companies
Fluctuation in earnings over different periods in time One approach taken is that if done correctly, DCF evens out fluctuations /volatility in the long term because all value is reduced to a single period However position of current year in cycle, needs to be factored in as it 91 is consideredwww.venturebean.com as base year
Cyclic companies
Growth rates in different years need to be adjusted based on expected cycles There may be difficulty in estimating cycles accurately If future differs from past, this would impact forecasts and therefore impact valuation
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Cyclic companies
It is important to have different possible scenarios and arrive at a range of values should be arrived This is useful as managers can implement decisions based on the valuation depending on the stage of the cycle the company is in (eg. for buyback, issue of shares, raising of debt funds)
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Companies in distress
May have one or all these problems Negative cash flow Unable to pay back debt Liquidity crunch
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Companies in distress
Valuing the company based on expectation of turnaround Assume the company will be healthy soon and look at future based on a healthier past Analyse based on future expected transaction in which cash flow is identifiable
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Companies in distress
Liquidation value Sum of parts based on individual identification of units
– Consider different alternate scenarios of units in different combinations – Consider all assets tangible and intangible
Cap at possible realisable value
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Cross border transactions
There are special issues in such cases, including Foreign exchange fluctuations Difference in regulations (statutory, accounting) Estimating cost of capital Country risks Inter country transactions
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Cross border transactions
Analyse past performance Translate Fx into host country financials, based on accounting standards Include any tax implication (eg subsidiary may pay dividend tax only if this is paid out) Arrive at FCF and convert to domestic currency
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Cross border transactions
Consider impact of restrictions on transfer of currency In place of FCF, multiples may also be used
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Cross border transactions
View impact of accounting regulations on financials
– Provisions (pension) – Goodwill (amortised or against equity) – Revaluation of assets – Deferred taxes – Fx translations – Non operating assets – Tax
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Cross border transactions
Cost of capital
– Market risk premium difficult to estimate, sometimes proxies are used – Risks in changing regulations – Political risks – Illiquid capital markets – Restrictions on cash flows
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Privatisation
Listed companies have the following which may lead to increased costs Increase in information to be provided per listing requirements Separation of ownership and management (good/bad?) Focus on stock prices at the cost of fundamental growth, in many cases
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Privatisation
Implication of privatisation Reduced access to finance Reduced visibility of company (impact on brand) Reduced requirement for compliance/governance
Impacts to be factored in for valuation, to the extent possible
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