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VALUATION APPROACHES. Valuations....drive the markets!!!. BSE Sensex. Prologue. In the financial services world, Valuations are used for various purposes For valuing the shares of a company In Mergers & Acquisitions In evaluation of new projects
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Valuations....drive the markets!!! BSE Sensex
Prologue • In the financial services world, Valuations are used for various purposes • For valuing the shares of a company • In Mergers & Acquisitions • In evaluation of new projects • However, the the basic principle of Valuations remain the same • What is the “Potential” of the business? • The word “Potential” refers to the future and thus most of the valuation approaches are about estimating the future and converting it into hard numbers • So it is not just financial concepts but ability to project and estimate the future potential • Discounted Cash Flow is the most robust methodology for valuations • This Valuation is then benchmarked against various proxies • Trading Comparables • Transaction Comparables
Valuation Methodologies Value Range Discounted Cash Flow Analysis Comparable Acquisitions Analysis Comparable Companies Analysis Sum of parts/ Asset Valuation • Trading valuation • Value based on market trading multiples of comparable companies • Acquisition valuation • Value based on multiples paid for comparable companies in sale transactions • Liquidation or break-up analysis – assets presumed to be representative of business value • Value of component parts – used when enterprise comprises of several discrete businesses • Inherent value of business • Present value of projected free cash flows
Enterprise Value v/s Equity Value Enterprise Value = Value of all the assets of a business Equity Value = Value of the shareholders’ equity Equity Value = Enterprise Value - Net Debt (1) Net Debt Enterprise Value Equity Value (or Market Value) • Unaffected by leverage • Multiples of: • Sales • EBITDA • EBIT • Size (such as capacity or number of users) • A function of leverage • Multiples of: • Net Income (Earnings) • After Tax Cash Flow • Book Value (1) Net Debt equals Total Long-Term Debt + Preferred Stock + Capitalized Leases + Short-Term Debt (other than working capital debt) - Cash and Cash Equivalents
A DCF valuation has three main components • Credible forecasts for the explicit period • Typically the horizon reflects the time in which steady state of business is achieved • Revenue, cost and capex forecasts used to derive the unlevered free cash flows to the company • These forecasts are validated through an understanding of industry, performance trends and outlook • Estimation of discount rate • Discounting of future cash flows to make them equivalent to present value • Discount rate is typically the cost of capital of target companies with profiles comparable to the target – essentially it should reflect the Opportunity Cost of Capital • Terminalvalue • Terminal value comprises of value of the cash flows beyond the explicit forecast period extending upto perpetuity • Captures value of the business that grows at a steady state growth rate
Unlevered Free Cash Flow • Unlevered free cash flow is the conceptual cash flow available for distribution to all capital providers • Tax shield effect of interest removed from cash flows to estimate unlevered free cash flows • Unlevered Free Cash Flow = After tax EBITDA - Capital Expenditures - Increase In Non-Cash Working Capital • EBITDA = EBIT + Amortization + Depreciation = Earnings before Depreciation, Interest, Taxes and Amortization • Non-Cash Working Capital = Non-Cash Current Assets - Non-Debt Current Liabilities
rex E D + E rd x D D + E + Principles of computation of Discount Rate • Weighted Average Cost of Capital or WACC used to discount free cash flows in order to estimate the present value of an enterprise • Defined as the weighted average sum of the cost of financing the enterprise, mainly through equity and debt • Cost of equity and cost of debt are weighted by the respective contributions of equity and debt in the steady state of business operations - to remove the effect of different financial structures in different companies • WACC = Where: E = Market Value of equity D = Market Value of debt (typically approximate with book value but be careful) re = return on equity derived from CAPM rd = after tax return on debt (assumed to be weighted average cost of debt) • CAPM assumes consistent, long-term target capital structure (D/E ratio) • Leveraged financing in maturing markets points to a Debt/Equity ratio of 30/70
Computation of WACC ingredients Cost of Debt Cost of Equity • Cost of Debt is the opportunity cost of lending, net of tax shield derived through leveraging • Cost of debt assumed at the prevailing long term lending rates for similar companies • Cost of debt = rd = Y (I - T) Where: rd = after tax-cost of long term debt (after tax)Y= gross redemption yield on debtT= effective marginal tax rate • Cost of equity represents the return expectations of equity shareholders from investment of comparable risk • Computed by adding a market risk premium weighted by comparable asset risk over the risk free return on a long term security • Cost of equity = re = rf + B *(rm - rf) Where: re= the required future market return on the equity of the Company rf = the risk free rate rm= the return on the market (factoring in the country risk also) B= the beta of the Company
FCF T+1 (WACC T+1 - g) Terminal value = Estimating the Terminal Value • Two basic methods used for computation of terminal value • Exit multiple basis (usually multiple of EBITDA – average of market related multiples ) • Perpetuity basis assumes that the free cash flows of the business would grow to perpetuity at a marginal steady rate • Both methods should produce similar results as EBITDA multiple should capture the perpetuity growth in value • May differ on account of trading liquidity/ speculative forces/ market risk/ differential information availability • Terminal value cash flow should also truly reflect a “steady state” • The later years in the explicit forecasts should have reached a constant state of growth in cash flows • capex/ROCE assumptions in the terminal year cash flows should be realistic • Any non steady state assumptions used to derive the terminal year cash flow must be removed e.g. the tax impact of any accumulated losses
Free Cash Flows : A Sample Steady state CF growth
Business Industry Products Distribution Channels Customers Seasonality Cyclicality End Markets Size Growth History and Growth Prospects Margins / Operating Track Record Location / Geographic Focus Ownership Profile / Liquidity Leverage / Capital Structure Dividend Yield / Payout Selection Criteria for Comparable Companies Primary Criteria Secondary Criteria • Having determined a set of sample companies, multiples on parameters such as earnings, EBITDA and book value are computed • The average multiple for each parameter considered is applied to the respective results of the target company to arrive at a range of valuation
Objectives of Comparisons of Acquisition Transactions • Measure “private” market value • Often a result of a combination of factors • Competitive bidding tension • Strategic value available – specific to individual buyers • Relative strength of target and buyer determined mainly by • Market position • Financial strength • Transactions may be structured as full auction, limited auction or bilateral negotiation • Privatisation transactions typically fall under full/ limited auctions • Methodology determined by • Need for transparency • Need for confidentiality • Universe of buyers • Complexity of transaction structuring • Enterprise Value may reflect not just the value of the target but also synergistic benefits available to buyer through other transaction agreements such as brand rights, distribution sharing, non-compete etc.
Multiples to be computed based on financials available at the time of the transaction Shares Outstanding for acquisition comparables consists of the fully diluted shares: shares outstanding (as of the latest financials available); plus shares pursuant to convertible securities (if in-the-money) Offer Price Per Share = price per share offered by the acquiror. In the case of an offer that includes stock, acquiror’s stock price one day prior to the announcement times the exchange ratio should be used Offer Value = offer price per share x shares outstanding Enterprise Value = offer value + non-convertible debt + non-convertible preferred + minority interest - cash & marketable securities Computation of multiples from “Acquisition” Comparables
Sample Valuation Summary using the methods illustrated above (US$ million) 655 650 625 630 500 465 460 355 335 260 EBITDA Multiple Method EBITDA PerpetualGrowthMethod EBITDA Subscribers DCF TradingMultiples Trading Multiples with 30% Assumed Premium AcquisitionMultiples The various methodologies yield an indicative valuation range between US$ 450 mn to US$ 550 mn
Template used for a Telecom DCF valuation and benchmarking Revenue assumptions Cost assumptions All India population Opex assumptions Penetration of total population Capex assumptions Market shares DCF Post paid and pre-paid WACC of 13% ARPU and MoUs Perpetuity Growth Projection Period of 11 years till FY 2016 Trading comparables Transaction comparables • Pure play listed mobile comparables not available in the Indian market • Bharti closest benchmark • Recently concluded transactions provide a framework of reference • Transaction comparables can be distorted by strategic considerations • Control premia and bidding environment need to be considered
Estimation of All India Population and Wireless Subscribers 1 Population and growth • All India wireless penetration • Gross additions & churn 4 Pre-paid/post-paid split Estimation of Based on Past trends and projections based on estimates by Indian Census and research reports Published industry research reports by Gartner, Morgan Stanley, Citigroup, Merrill Lynch and Lazard estimates Lazard estimates of fair share of gross adds in the respective circles Past trends and projections based on Lazard estimates and Industry research Top Down Approach Three separate cases have been considered for the purposes of valuation. In the “Base Case” all India wireless penetration is assumed to reach 25% in FY 2016 with a CAGR of 17.8%
Key Assumption for ARPU and Key Costs Key Assumptions For Estimating ARPU Key Assumptions For Estimating Operating Costs • Activation Fee per Gross Add : is assumed to decline by 10% yoy • Monthly Access/ Recharge Charge per Sub : is assumed to decline by 5% yoy • Outgoing Airtime rate : is assumed to decline by 5% in FY 2006. • VAS : is assumed to stabilise at 20% of voice revenues in FY 2011; metro VAS assumed higher - stabilises at 30% • Gross Outroaming : is projected to stabilise at 10% of voice revenues by FY 2009 • Interconnect Pass Through Charges: is assumed at 20% of gross revenue • Network Operating Costs : have been estimated at Rs 0.2 / min of usage • License Fee : have been estimated at 10%, 8% & 6% of net revenues for Metro, Circle A & Circle B respectively • Employee Costs: Cost per employee is assumed to grow at 10% yoy • Customer Acquisition Costs: have been assumed at the FY 2005 levels of Rs 790 / postpaid gross add and Rs 187/ prepaid gross add • Advertisement Costs: have been increased to 7.0% of net revenues in FY 2008 and thereafter remain constant during the projection period Key Assumptions For Estimating Capex • Incremental capex is estimated at $ 75 per incremental subscriber during the projection period • Maintenance capex is estimated at $ 5 per opening subscriber during the projection period
Key Outputs – Subs and ARPU Total All India Subscribers Total Company Subscribers • ARPU is projected to decline in line with industry trends • Proportion of Prepaid subscribers is projected to increase to 86.4% in the terminal year Company’s ARPU * CAGR for the period FY 2005 – FY 2016
Benchmarking With Industry Estimates CAGR* All India Subscribers • Key outputs from the model have been benchmarked against research published by leading houses such as Gartner, Morgan Stanley, Citigroup & Merrill Lynch • The all India subscriber and penetration projections are lower than benchmarks 28.8% 55.6% 42.8% 38.0% 34.0% All India Wireless Penetration * Lazard – 4 year CAGR, Gartner – 4 year CAGR, Morgan Stanley/Merrill Lynch – 3 year CAGR, Citigroup – 2 year CAGR
Benchmarking With Industry Estimates All India ARPU • Overall ARPU in the “Base Case” is much lower than the comparables in the initial 2 years of the projection period and thereafter follow the market trend of steady de-growth • ARPU in the model is assumed to reduce from Rs 375 / sub in FY 2005 to Rs 282 / sub in the terminal year representing a CAGR of –2.6% • ARPU decline is on account of • Decline in Activation & Access fees by 10% and 5% yoy • Decrease in call charges • Minutes of Usage(MoUs) are assumed to behave inversely with the call charges All India ARPU Growth
ARPU & Key Components of ARPU ARPU Breakup of ARPU
Costs • Network operation costs form the largest chunk of the costs accounting for 37% of the total costs in FY 2016 • Employee costs have been assumed to grow to 20% of total costs from the 11% in FY 2005 • Advertisement and business promotions costs are projected to counteract increasing competition in all the operating circles • Bad debts are projected to decrease as a proportion of total costs due to the increase in quality of postpaid subscribers
Capex Assumptions & Projections • Key Assumptions • Capex for incremental growth as well as maintenance of service quality/ enhancements have been estimated on comparable benchmarks • Incremental capex is estimated at $ 75 per incremental subscriber in during the projection period • Maintenance capex is estimated at $ 5 per opening subscriber during the projection period
Projected Profit & Loss Account * Projected P&L for FY 2005 in the original model. PBT includes other income of Rs 131 million
Free Cash Flows Steady state CF growth
Valuation under Other Scenarios • Valuation have been considered for two further scenarios - Pessimistic & Optimistic • Pessimistic Scenario • Terminal year all India wireless penetration 20% with a CAGR of wireless subscribers at 15.3% as compared to a penetration of 25% in the Base scenario • Perpetuity growth rate assumed at 2% as compared to 3% in the Base Scenario • Resultant all India market share in FY 2016 is 11.5% as compared to 12.1% in the Base Scenario • Optimistic Scenario • Terminal year all India wireless penetration 30% with a CAGR of 19.8% • Perpetuity growth rate assumed at 4% • Resultant all India market share in FY 2016 is 12.8%
Benchmark Valuations in recent telecom transactions SingTel’s stake enhancement in Bharti
Benchmarking with Trading and Transaction Comps * Prices based on existing capital base
In Summary ... • Valuations are more about rigour in implementing the concepts than about concepts • Every valuation is different • Industry to industry • Company to company • Of a company at different times • Though a thorough understanding of concepts is important to use them in different scenarios • Different growth parameters – how to use them? • Tax issues • Carry forward losses and their treatment • Split period approaches • Terminal Value impact • A thorough understanding of the industry, company, environment around it is very important • And lastly, an excellent hold over spreadsheet is critical … • Makes the difference between a good valuation and a not so good one … Thank You
