Corporate Valuation

1. Corporate Valuation Use of Different Terms

2. CORPORATE VALUATION • In the context of M&A, value means economic value i.e. amount to be paid in exchange for an asset or the right to receive future benefits from the use of that asset. Economic value is, therefore, the monetary worth of an asset. • Various concept s of value • Fair market value – amount mutually accepted by buyer & seller • Investment value – value of the future benefits of ownership • Fair value – statutory standard of value • Intrinsic value – value, especially of stocks, based on earning power and earnings quality of the investment • Goodwill value – difference between the price paid and the fair value • Going concern value – value of the maintainable income of the firm at a suitable capitalisation rate • Book value – net worth or book equity

3. CORPORATE VALUATION • Liquidation value – forced and orderly • Replacement value • Salvage value

4. VALUATION APPROACHES • 4 broad approaches to appraising value of a company • Adjusted book value approach • Stock and debt approach • Direct comparison approach • Discounted cash flow (DCF) approach Adjusted Book Value Approach • Based on data found in balance sheet • First book values of investor claims summed • Second, total non-investor claims (accounts payable) deducted from total assets of the company

5. ADJUSTED BOOK VALUE APPROACH

6. ADJUSTED BOOK VALUE APPROACH • Accuracy of the book value approach depends on how well the net book values of the assets reflect their fair market values. 3 reasons why book values may diverge from market values • Inflation – book value typically at historical cost less depreciation. Does not consider inflation • Obsolescence – assets may be obsolete though not yet fully depreciated • Organisational capital/ goodwill – not shown in the balance sheet but influences market value • Adjusting book value to reflect replacement cost : Though asset’s earning power not directly related to book value, in case the asset is old, it is likely to be related to current replacement cost • Cash – no change • Debtors – usually at face value but allowance for bad debts based on quality of debtors

7. ADJUSTED BOOK VALUE APPROACH • Inventory – RM – current cost of acquisition, WIP – process cost, FG – realizable sales price • Other current assets – deposits, prepaid exp, accruals etc. – at face value • Fixed assets • Land – market value • Bldg & civil works – replacement cost less physical depreciation and deterioration • P&M – mkt price of used asset+cost of transportation and installation • Non operating assets – investments (securities, land, property etc.) – valued at fair market value • Adjusting book values to reflect liquidation values • In case of active secondary market, then liquidation value equals market price • Lack of active secondary markets for many assets. Hence technical appraisal a must to arrive at hypothetical price of the asset

8. ADJUSTED BOOK VALUE APPROACH • Two weaknesses with this approach • Ignores organisation capital/ goodwill • Does not value the firm as a going concern; considers piecemeal sale of assets and hence relevant in case of a firm which is expected to decline. • This approach has limited applicability due to the above reasons.

9. STOCK AND DEBT APPROACH • When securities of a firm are publicly traded, firm value = summation of market value of all outstanding securities • Commonly used by property tax appraisers. Also referred to as market approach • Issues arise about what prices to use when valuing the securities particularly equity shares. Usually averaging recommended to overcome volatility – logic is that averaging provides more reliable estimate of the firm’s true underlying value. • However, averaging implies lack of efficient stock markets. If prices reflect all publicly available information, then no need for averaging • 2 important points to remember • Where stock and debt approach can be employed, will produce the most reliable estimate of value • In case of efficient markets, securities should be valued at the lien date (day on which appraiser is attempting to value). Averaging should be avoided as it reduces the accuracy of appraisal

10. DIRECT COMPARISON APPROACH • Value an asset by looking at the price at which a comparable asset has changed hands between a reasonably informed buyer and seller. • Commonly applied in real estate. However, impact in differences of scale have to be factored • The approach can be reflected in a simple formula VT = Xt * VC / Xc ,where VT = appraised value of target firm/ asset Xt = observed variable for target firm that drives value VC = value of comparable firm Xc = observed variable for comparable company

11. DIRECT COMPARISON APPROACH

12. STEPS IN DIRECT COMPARISON APPROACH • Analyse the economy • Analyse the industry • Analyse the subject company • Select comparable companies • Analyse subject and comparable companies • Analyse multiples • Care should be taken to choose appropriate variable. Usually financial variables chosen • Consistency essential while comparing variables • Few commonly used ratios/ multiples • Firm value to sales • Firm value to book value of assets • Firm value to PBIDT • Firm value to PBIT • P/ E multiple • Equity value to net worth (market-book ratio) • Value the subject company

13. STEPS IN DIRECT COMPARISON APPROACH • It is a popular method because it relies on multiples that are easy to get • Especially useful when comparable companies are traded and priced fairly • However, few drawbacks exist • Multiples amenable to misuse and manipulation • Choice of comparable companies subjective as companies differ in terms of risk and growth • Multiples used reflect valuation errors (under or over) of the market. E.g., software companies

14. Exercise 1 Novelty, a consumer durable manufacturer, reported earnings per share of Rs.3.20 in 2005 and paid dividends per share of Rs.1.7 in that year. The firm reported depreciation of Rs.350 lakh in 2005 and capital expenditures of Rs.475 lakh. There were 160 lakh outstanding shares traded at Rs.51 per share. The ratio of capital expenditure to depreciation is expected to be maintained in the long term. The working capital needs are negligible. Novelty had a debt outstanding of Rs.1600 lakh and intends to maintain its current financing mix of debt and equity to finance future investment needs. The firm is in the steady state, and earnings are expected to grow at 7% per year. The stock had a Beta of 1.05, the Treasury bill rate is 6.25% and the market premium is 5.5%. • Estimate the value per share using the dividend discount model. • Estimate the value per share, using the FCFE model. • How would you explain the difference between the two models, and which one would you use as a benchmark to compare with the market price?

15. Solution 1 Earnings per share = Rs.3.2 Dividend per share = Rs.1.7 Depreciation = Rs.350 lakh Capital Expenditure = Rs.475 lakh Number of shares = 160 lakh Market price per share = Rs.51 per share Cost of Equity: ke = Rf + β (Rm – Rf) = 6.25 + 1.05 (5.5) = 12.025% • Estimation of Value per Share using the Dividend Discount Model Value of equity = D1 / (ke – g) D1 = D0 (1 + g) Value of Equity = 1.70 (1.07) / (0.12025 – 0.07) = 1.819 / 0.05025 = Rs.36.199 or Rs.36.20 app.

16. Solution 1 Contd. • Estimation of Value per Share using the FCFE Model FCFE = Net income – (Capital expenditure – Depreciation) (1 – Debt financing ratio) – Change in working capital (1 – Debt financing ratio) Depreciation per share = 350 / 160 = Rs.2.1875 Capital expenditure per share = 475 / 160 = Rs.2.968 Debt financing ratio = Debt / (Debt + Equity) = 1,600 / (1,600 + 8,160) = 16.39% FCFE = 3.2 – (2.968 – 2.1875) (1 – 0.1639) = 3.2 – (0.7805) (0.8361) = Rs.2.5474 Value of the share = 2.5474 (1.07) / (0.12025 – 0.07) = 2.7257 / 0.05025 = Rs.54.24 • The FCFE is greater than the dividends paid. The higher value from the model reflects the additional value from the cash accumulated in the firm. The FCFE is a more suitable model because it is a more realistic model.

17. Exercise 2 Sun Ltd. projects the following figures for the financial year 2008-2009. Net Income after tax = Rs.130 crores. Depreciation = Rs.50 crores. Capital expenditure planned = Rs.80 crores. Additional working capital needed = Rs.25 crores. Principal repayment of debt = Rs.10 crores. As the firm has a very low debt equity ratio , it plans to increase its leverage by financing debt repayment and 30% of the planned capital expenditure and additional working capital needs by raising fresh debt. Project the free cash flow to equity for 2008-2009.

18. Solution 2 Free Cash flow to equity (FCFE) = Net income after tax + depreciation - Capital expenditureworking capital+ proceeds from new debt issues. Step 1 = calculate new debt issued in 2008-09. New debt = principal repayment + 30% of capital expenditure and working capital =10crores + 0.3(80+25 crores) =41.5 crores. Step 2 = calculate FCFE Rs.Cr Net income after tax 130 Add depreciation 50 less capital exp. -80 less working capital -25 less debt repayment -10 add new debt issued 41.5 Free cash flow to equity 106.5

19. Exercise 3 Z Ltd. Is planning a public issue and would like to value the company using the comparable companies approach. Based on the following data from 2 comparable companies X / Y Ltd. identify 4 ratios / indicators for comparable analysis and value Z Ltd. Give equal weight age to all the ratios / indicators in the valuation.

20. Solution 3 Step 1 - Identify and Estimate ratios / indicators of comparable companies X/Y Ltd. Step 2 - Apply the average comparable ratios to the data of Z Ltd. Z Ltd. Avg .ratio Value of Z Ltd. Average of the 4 values 726.69 So market value of Z Ltd. Will be say Rs. 727.

21. Exercise 4 The following details are available with regard to the projected operations of Pragati Enterprises Ltd.

22. Exercise 4 Contd. The company has long-term debt carrying an interest rate of 12.5% and has some non-interest bearing current liabilities. The cost of equity capital is 16 percent. The company does not have any other long-term sources of finance. The market value of equity is Rs.50 lakh and the market value of debt is Rs.30 lakh. The effective tax rate applicable to the company is 36 percent. From the sixth year onwards, the free cash flow of the company is expected to grow at the rate of 8 percent per annum. You are required to calculate the value of the company using the discounted cash flow approach.

23. Solution 4 Gross cash flow for the explicit forecast period Calculation of gross investment

24. Solution 4 contd. Calculation of free cash flow (Rs. in lakh) Cost of capital = (k) = 30 0.125 (1 – 0.36) + 50 0.16 = 0.13 i.e.13% 30+50 30+50 Present value of free cash flow = 22.8 + 26 + 48.7 + 56.2 + 86.6 = Rs.155.76 lakh 1.13 1.132 1.133 1.134 1.135 Continuing value = 86.6 x 1.08 0.13 – 0.08 = 1870.56

25. Solution 4 Contd. PV of Continuing value = 1870.56 (1.13)5 = 1015.27 L Value of the firm = 1015.27 + 155.76 = 1171.03 L

26. Exercise 5 Amol Industries is in Professional Services business.The company financial are as follows:

27. Exercise 5 Contd. Year wise investments in Fixed Assets: (Rs.Million) You are required to find out the value of Amol Industries.

28. Rs. Lakhs

29. Solution 5 Contd. Cost of Capital: (0.08*40/150) + (0.15*110/150) = 13.13% Present Value of Free Cash Flow: Rs. Lakhs Discounted continuing Value: 66(1.1) / (0.1313 - 10) = 2319 x 1= 1251.7 1.13135 Value of the firm = 176.10 + 1251.7 = 1428 Market Value of Equity = 1388 lakhs.