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## Chapter 32 CORPORATE VALUATION

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**Chapter 32**CORPORATE VALUATION Centre for Financial Management , Bangalore**OUTLINE**• Importance of valuation • Goal of valuation • Adjusted book value approach • Analysing historical performance • Discounted cash flow approach • Estimating the cost of capital • Forecasting performance • Determining the continuing value • Calculating the firm value and interpreting the results • DCF valuation: 2-stage and 3-stage growth models • Free cash flow to equity valuation • Guidelines for equity valuation Centre for Financial Management , Bangalore**IMPORTANTCE OF VALUATION**In the wake of economic liberalisation, companies are relying more on the capital market, acquisitions and restructuring are becoming commonplace, strategic alliances are gaining popularity, employee stock option plans are proliferating, and regulatory bodies are struggling with tariff determination. In these exercises a crucial issue is: How should the value of a company or a division thereof be appraised? Centre for Financial Management , Bangalore**GOAL OF VALUATION**The goal of such an appraisal is essentially to estimate a fair market value of a company. So, at the outset, we must clarify what is meant by “fair market value” and what is meant by “a company”. The most widely accepted definition of fair market value was laid down by the Internal Revenue Service of the US. It defined fair market value as "the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” When the asset being appraised is “a company”, the property the buyer and the seller are trading consists of the claims of all the investors of the company. This includes outstanding equity shares, preference shares, debentures, and loans. Centre for Financial Management , Bangalore**APPROACHES TO VALUATION**• There are four broad approaches to appraising the value of a company: • Adjusted book value approach • Stock and debt approach • Direct comparison approach • Discounted cash flow approach Centre for Financial Management , Bangalore**ADJUSTED BOOK VALUE APPROACH**1. VALUE THE ASSETS · CASH · DEBTORS · INVENTORIES · OTHER CURRENT ASSETS · FIXED TANGIBLE ASSETS · NON-OPERATING ASSETS · INTANGIIBLE ASSETS 2. VALUE THE LIABILITIES · LONG-TERM DEBT · CL & PROVISIONS 3. ASSESS THE OWNERSHIP VALUE REASONS WHY THE BOOK VALUE DIVERGES FROM MARKET VALUE · INFLATION · OBSOLESCENCE · ORGANISATIONAL CAPITAL WHY REASONABLE · REGULATED INDUSTRIES ADJUSTMENTS TO BOOK VALUE · TO REFLECT REPLACEMENT COST · TO REFLECT LIQUIDATION VALUE Centre for Financial Management , Bangalore**BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 2001 (**Rs in million) CAPITAL AND LIABILITIESASSETS SHARE CAP 15.0 FIXED ASSETS 33.0 RES. AND SURP 11.2 INVESTMENTS 1.5 LOAN FUNDS 21.2 CURRENT ASSETS 23.4 CURR LIAB 10.5 57.9 57.9 BALANCE SHEET VALUATION INVESTOR CLAIMS APPROACHASSET-LIABILITIES APPROCH SHARE CAP 15.0 TOTAL ASSETS 57.9 RES. AND SURP 11.2 LESS : CURRENT LIAB 10.5 LOAN FUNDS 21.2 47.4 47.4 Centre for Financial Management , Bangalore**STOCK AND DEBT APPROACH**• PUBLICLY TRADED • WHAT PRICE ? • AVERAGING ? • EMH . . . • TWO IMPLICATIONS • • S & D . . MOST RELIABLE ESTIMATE OF VALUE • • SECURITIES . . VALUED . . LIEN DATE Centre for Financial Management , Bangalore**DIRECT COMPARISON APPROACH**Common sense and economic logic tell us that similar assets should sell at similar prices. Based on this principle, one can value an asset by looking at the price at which a comparable asset has changed hands between a reasonably informed buyer and a reasonably informed seller. This approach, referred to as the direct comparison approach, is commonly applied in real estate. Essentially, the direct comparison approach is reflected in a simple formula: Vc VT = xT . (32.1) xc where VT = appraised value of the target firm (or asset) xT= observed variable for the target firm that supposedly drives value Vc = observed value of the comparable firm xc = observed variable for the comparable company Centre for Financial Management , Bangalore**STEPS IN APPLYING THE**DIRECT COMPARISON APPROACH • Operationally, a top-down procedure may be followed in applying the direct comparison approach. This involves the following steps: • Analyse the economy • Analyse the industry • Analyse the subject company • Select comparable companies • Analyse subject and comparable companies • Analyse multiples • Value the subject company Centre for Financial Management , Bangalore**COMPARABILITY**• SIZE • BUSINESS PORTFOLIO • GEOGRAPHIC DIVERSIFICATION • OPERATING LEVERAGE • DIFFERENCES IN MARGINS AND MARKET SHARES • DIFFERENCES IN EFFICIENCY & ECONOMIES OF SCALE • CAPITAL STRUCTURE • ACCOUNTING POLICIES • MULTIPLES • ·PRICE TO SALES • · PRICE TO EBDIT • · PRICE TO EBIT • · PRICE TO EARNINGS • · PRICE TO CASH FLOW • · PRICE TO BOOK VALUE Centre for Financial Management , Bangalore**ILLUSTRATION** Centre for Financial Management , Bangalore**ILLUSTRATION**• . • Taking into account the characteristics of company D vis-à-vis companies A,B, and C, the following multiples appear reasonable for company D: • MV/PBDIT = 17 MV/Book value = 3.0 MV/Sales = 2.2 • Applying these multiples to the financial numbers of company D, we get the following value estimates: • 1. MV = 17 x PBDIT = 17 x 18 = Rs.306 million • 2. MV = 3 x Book value = 3 x 90 = Rs.270 million • 3. MV = 2.2 x Sales = 2.2 x 125 = Rs.275 million • A simple arithmetic average of the three value estimates is : • (306 + 270 + 275) / 3 = Rs.283.7 million Centre for Financial Management , Bangalore**PROS AND CONS OF MARKET APPROACH**• MULTIPLES ARE SIMPLE AND EASY TO RELATE TO • MULTIPLES ARE AMENABLE TO MISUSE AND MANIPULATE • • CHOICE OF COMPARABLE COMPANIES DISGUISES SUBJECTIVE BIAS –IN DCF APPROACH ASSUMPTIONS HAVE TO BE MORE EXPLICIT. • BUILDS IN ERRORS OF MARKET VALUATION • • DCF VAL’N . . BASED . . ON FIRM SPECIFIC GROWTH RATES & CASH SPECIFIC GROWTH RATES & CASH FLOWS Centre for Financial Management , Bangalore**DISCOUNTED CASH FLOW APPROACH**• Valuing a firm using the DCF approach is conceptually identical to valuing a project using the present value method. However, there are two important differences: • While a capital project is deemed to have a finite life, a • firm is considered as an entity that has an indefinite life. • A capital project is typically valued as a ‘one-off’ • investment. A firm, however, is viewed as a growing • entity requiring continuing investments Centre for Financial Management , Bangalore**DISCOUNTED CASH FLOW APPROACH**To sum up, valuing a firm using the discounted cash flow approach calls for forecasting cash flows over an indefinite period of time for an entity that is expected to grow. This is indeed a daunting proposition. To tackle this task, in practice, the value of the firm is separated into two time periods: Value of the firm = Present value of cash flow + Present value of cash flow during an explicit forecast after the explicit forecast period period During the explicit forecast period – which is often a period of 5 to 15 years – the firm is expected to evolve rather rapidly and hence a great deal of effort is expended to forecast its cash flow on an annual basis. At the end of the explicit forecast period, the firm is expected to reach a “steady state” and hence a simplified procedure is used to estimate its continuing value Centre for Financial Management , Bangalore**DISCOUNTED CASH FLOW APPROACH**• Thus, the discounted cash flow approach to valuing a firm • involves the following steps: • Analysing historical performance • Estimating the cost capital • Forecasting performance • Determining the continuing value • Calculating the firm value and interpreting the results. Centre for Financial Management , Bangalore**ANALYSING HISTORICAL PERFORMANCE**• Inter alia, historical performance analysis should focus on: • Extracting valuation related metrics from accounting • statements. • Calculating the free cash flow and the cash flow available • to investors • Getting a perspective on the drivers of free cash flow • Developing the ROIC tree Centre for Financial Management , Bangalore**Financial Statements of Matrix Limited for the Preceding**Three Years (Years 1-3) Centre for Financial Management , Bangalore**BALANCE SHEET**1 2 3 Equity capital 60 90 90 Reserves & surplus 40 49 61 Debt 100 119 134 Total 200 258 285 Fixed assets 150 175 190 Investment - 20 25 Net current assets 50 63 70 Total 200 258 285 Centre for Financial Management , Bangalore**Extracting Valuation Related Metrics from Accounting**Statements The accounting statements must be reorganised to get a handle over the following operating invested capital, NOPLAT, ROIC, and net investment. Operating Invested Capital The capital provided by shareholders and lenders is invested in operating assets (operating invested capital) an non-operating assets. Operating invested capital consists of net fixed assets deployed in the operations of the firm plus the operating working capital (operating working assets minus non-interest bearing current liabilities). In practice, operating invested capital may be obtained as follows: Total assets in the balance sheet - Non-operating fixed assets like surplus land - Excess cash and marketable securities1 1 This represents cash and marketable securities in excess of the operational needs of the firm. Centre for Financial Management , Bangalore**Extracting Valuation Related Metrics from Accounting**Statements If we assume that the investment figures of 20 and 25 in the balance sheet of Matrix Limited at the end of years 2 and 3 represent excess cash and marketable securities, the operating invested capital at the end of years 1, 2, and 3 for Matrix Limited is: 1 2 3 Operating invested 200 238 260 capital Centre for Financial Management , Bangalore**NOPLAT NOPLAT stands for net operating profit less adjusted**taxes. It is equal to: EBIT – Taxes on EBIT EBIT is the pre-tax operating income the firm would have earned if it had no debt. While calculating EBIT, the following are excluded: interest expenses, interest income, and non-operating income (or loss). Taxes on EBIT represents the taxes the firm would pay if it had no debt, excess marketable securities, or non-operating income (or loss). Taxes on EBIT can be calculated by adjusting the income tax provision for the income tax attributable to interest expense, interest and dividend income from excess marketable securities and, non-operating income (or loss). Centre for Financial Management , Bangalore**The calculation of NOPLAT for Matrix Limited is shown below** Centre for Financial Management , Bangalore**Return on Invested Capital**Return on invested capital, ROIC, is defined as follows: NOPLAT ROIC = Invested capital Invested capital is usually measured at the beginning of the year or as the average at the beginning and end of the year. While calculating ROIC, define the numerator and denominator consistently. If an asset is included in invested capital, income related to it should be included in NOPLAT to achieve consistency. The ROIC for Matrix Limited is calculated below: Year 2 Year 3 NOPLAT 30 27 Invested capital at the 200 238 beginning of the year ROIC 30/200 = 15% 27/238 = 11.3% ROIC focuses on the true operating performance of the firm. It is a better measured compared to return on equity and return on assets. Return on equity reflects operating performance as well as financial structure and return on assets is internally inconsistent (numerator and denominator are not consistent). Centre for Financial Management , Bangalore**Net Investment**Net investment is the difference between gross investment and depreciation: Net investment = Gross investment - Depreciation Gross investment is the sum of incremental outlays on capital expenditures and net working capital. Depreciation refers to all non-cash charges. Alternatively, net investment during the year can be calculated as follows: Net fixed assets at the end + Net current assets at the of the year end of the year - Net fixed assets at the + Net current assets at the end beginning of the year of the year Calculated in this manner, the net investment for Matrix Limited is shown below Year 2Year 3 Net fixed assets at the end 175 190 of the year + Net current assets at the 63 70 at the end of the year - Net fixed assets at the beginning 150 175 of the year - Net current assets at the 50 63 beginning of the year 38 22 Centre for Financial Management , Bangalore**Calculating the Free Cash Flow**The free cash flow (FCF) is the post-tax cash flow generated from the operations of the firm after providing for investments in fixed investment and net working capital required for the operations of the firm. FCF can be expressed as: FCF = NOPLAT - Net investment FCF = (NOPLAT + Depreciation) - (Net investment + Depreciation) FCF = Gross cash flow - Gross investment Exhibit shows the FCF calculation for Matrix Limited Matrix Limited Free Cash Flow Year 1 Year 2 Year 3 NOPLAT 25.2 30.0 27.0 Depreciation 12 15 18 Gross cash flow 37.2 45 45 (Increase)/decrease in 13 7 working capital Capital expenditure 40 33 Gross investment 53 40 Free cash flow (8) 5**CASH FLOW AVAILABLE TO INVESTORS**The cash flow available to investors (shareholders and lenders) is equal to free cash flow plus non-operating cash flow .We have discussed what free cash flow is. What is non-operating cash flow? Non-operating cash flow arises from non-operating items like sale of assets, restructuring, and settlement of disputes. Such items must, of course, be adjusted for taxes. Centre for Financial Management , Bangalore**FINANCING FLOW**The cash flow available to investors can also be viewed as the financing flowwhich is derived as follows: Financing flow = After-tax interest expense + Cash dividend on equity and preference capital + Redemption of debt - New borrowings + Redemption of preference shares + Share buybacks - Share issues + Δ Excess marketable securities - After-tax income on excess market securities The last two items in the above expression require some clarification. Excess marketable securities are regarded as negative debt. So, a change in excess marketable securities is treated a financing flow. For the same reason, the post-tax income on excess marketable securities is regarded as a financing flow. Centre for Financial Management , Bangalore**MATRIX LIMITED – CASH FLOW AVAILABLE TO INVESTORS** Centre for Financial Management , Bangalore**GETTING A PERSPECTIVE ON THE DRIVERS OF FCF**The FCF may be analysed in terms of its key drivers as follows: FCF = NOPLAT – Net Investment = NOPLAT 1 – Net Investment NOPLAT = Invested Capital NOPLAT 1 – Net Investment Invested Capital NOPLAT = Invested Capital NOPLAT` 1 – Net Investment / Invested Capital Invested Capital NOPLAT / Invested Capital Growth rate = Invested capital x ROIC x 1 - ROIC**Thus, invested capital, ROIC, and growth rate are the basic**drivers of FCF. The drivers of FCF for Matrix Limited for the years 2 and 3 are given below: • Year 2 Year 3 • Invested capital Rs.200 million Rs.238 million • Beginning of the year) • NOPLAT Rs.30 million Rs.27 million • NOPLAT • ROIC = 15.00% 11.3 % • Invested capital • Net investment Rs.38 million Rs.22 million • Net investment • Growth rate = 19.00% 9.2% • Invested capital • FCF -Rs.8 million Rs.5 million Centre for Financial Management , Bangalore**DEVELOPING THE ROIC TREE**As ROIC is a key driver of free cash flow and valuation, it is useful to develop the ROIC tree which disaggregates ROIC into its key components. The starting point of the ROIC tree is: NOPLAT ROIC = Investment Since NOPLAT is equal to EBIT times (1-cash tax rate), ROIC can be expressed as pre-tax ROIC times (1-cash tax rate): EBIT ROIC = (1- Cash tax rate) Invested capital Pre-tax ROIC can be broken down into two components as follows: EBIT EBIT Revenues = x Invested capital Revenues Invested capital Operating Capital Margin turnover The first term, viz, operating margin measures how effectively the firm converts revenues into profits and the second term, viz, capital turnover reflects how effectively the company employs its invested capital. Each of these two components can be further disaggregated. Exhibit 32.6 shows the ROIC tree for Matrix Limited.**Matrix Limited – ROIC Tree for Year 3** Centre for Financial Management , Bangalore**COST OF CAPITAL**• The cost of capital is the discount rate used for converting the expected free cash flow into its present value. It • Represents the weighted average of the costs of all sources • of capital • Is calculated in post-tax terms • Is defined in nominal terms • Is based on market value weights • Is adjusted for risk Centre for Financial Management , Bangalore**FORMULA**The formula that may be employed for estimating the weighted average cost of capital is: WACC = rE (S/V) + rP (P/V) + rD(1-T) (B/V) (32.1) where WACC = weighted average cost of capital rE = cost of equity capital S = market value of equity V = market value of the firm rp= cost of preference capital P = market value of preference capital rD = pre-tax cost of debt T = marginal rate of tax applicable B = market value of interest-bearing debt Centre for Financial Management , Bangalore**MATRIX’S WEIGHTED AVERAGE**COST OF CAPITAL Matrix Limited has a target capital structure in which debt and equity have weights (in market value terms) of 2 and 3. The component costs of debt and equity are 12.67 percent and 18.27 percent. The marginal tax rate for Matrix is 40 percent. Given this information the, weighted average cost of capital is calculated as follows: 3 2 WACC = x 18.27 + x 12.67% (1 - .4) 5 5 = 10.96 + 3.04 = 14 percent Centre for Financial Management , Bangalore**FORECASTING PERFORMANCE**• After analysing historical performance and estimating the cost of capital, we move on to developing a financial forecast. This involves the following steps. • Selecting the explicit forecast period. • Developing a strategic perspective on the future performance of the company. • Converting the strategic perspective into financial forecasts. • Checking for consistency and alignment. Centre for Financial Management , Bangalore**SELECTING THE EXPLICIT FORECAST PERIOD**The general guideline is that the explicit forecast period should be such that the business reaches a steady state at the end of this period. This condition has to be satisfied because typically the continuing value formula is based on the following assumptions: (i) The firm earns a fixed profit margin, achieves a constant asset turnover, and hence earns a constant rate of return on the invested capital. (ii) The re-investment rate (the proportion of gross cash flow invested annually) and the growth rate remain constant. Centre for Financial Management , Bangalore**DEVELOPING A STRATEGIC PERSPECTIVE**• The strategic perspective reflects a credible story about the • company’s future performance. One such story about a • telecom software provider is given below for illustrative • purposes: • “ The global telecom market is recovering. The company is well-positioned in those segments of the telecom market which are growing rapidly. The company has restructured its licensing arrangements with its customers and this is expected to augment its overall income from licensing. The combination of these factors is expected to generate a robust growth in revenues and improve the net profit margin over the next five years.” Centre for Financial Management , Bangalore**CONVERTING THE STRATEGIC PERSPECTIVE INTO A FINANCIAL**FORECAST Once you have crafted a story about the company’s future performance, you have to develop a forecast of free cash flow. Sometimes the free cash flow forecast is developed directly without going through the profit and loss account and the balance sheet. However, it is advisable to base the free cash flow forecast on an integrated profit and loss account and balance sheet forecast. This provides a proper perspective on how the various elements fit together. Centre for Financial Management , Bangalore**CONVERTING THE STRATEGIC PERSPECTIVE INTO A FINANCIAL**FORECAST • For non-financial companies, the most common method for forecasting the • profit and loss account and the balance sheet is as follows: • Develop the revenue forecast on the basis of volume growth and price changes. • Use the revenue forecast to estimate operating costs, working capital, and fixed assets. • Forecast non-operating items such as investments, non-operating income, interest expense, and interest income. • Project net worth. Net worth at the end of year n is equal to net worth at the end of year n-1, plus the amount ploughed back from the earnings of year n, plus new share issues during year n, minus share repurchases during year n. • Use the cash and / or debt account as the balancing account. Centre for Financial Management , Bangalore**Projected Profit and Loss Account and Balance Sheet for**Matrix Limited for Five Years – Years 4 through 8 – The Explicit Forecast Period Rs. in million Centre for Financial Management , Bangalore**Free Cash Flow Forecast for Matrix Limited for Five Years**– Years 4 through 8 – The Explicit Forecast period Centre for Financial Management , Bangalore**CHECKING FOR CONSISTENCY AND ALIGNMENT**• The final step in the forecasting exercise is to evaluate the forecast for consistency and alignment by asking the following questions. • Is the projected revenue growth consistent with industry growth? • Is the ROIC justified by the industry’s competitive structure? • What will be the impact of technological changes on risk and returns? • Is the company capable of managing the proposed investments? • Will the company be in a position to raise capital for its expansion • needs? • Because ROIC and growth are the key drivers of value, let us look at how companies have performed on these parameters. Empirical evidence suggest that: • Industry average ROICs and growth rates are related to economic fundamentals. For example, the pharmaceutical industry, thanks to patent protection, enjoys a higher ROIC whereas the automobile industry earns a lower ROIC because of its capital intensity. • It is very difficult for a company to out perform its peers for an extended period of time because competition often catches up, sooner or later. Centre for Financial Management , Bangalore**DETERMINING THE CONTINUING VALUE**• As discussed earlier, a company’s value is the sum of two terms: • Present value of cash flow during + Present value of cash flow the explicit forecast period after the explicit forecast period • The second term represents the continuing value or the terminal value. It is the value of the free cash flow beyond the explicit forecast period. Typically, the terminal value is the dominant component in a company’s value. Hence, it should be estimated carefully and realistically. • There are two steps in estimating the continuing value: • Choose an appropriate method • Calculate the continuing value Centre for Financial Management , Bangalore**CHOOSING AN APPROPRIATE METHOD**A variety of methods are available for estimating the continuing value. They may be classified into two broad categories as follows: Centre for Financial Management , Bangalore**GROWING FREE CASH FLOW PERPETUITY METHOD**This method assumes that the free cash flow would grow at a constant rate for ever, after the explicit forecast period, T. Hence, the continuing value of such a stream can be established by applying the constant growth valuation model: FCFT+1 CVT = (32.2) WACC – g where CVT is the continuing value at the end of year T, FCFT+1 is the expected free cash flow for the first year after the explicit forecast period, WACC is the weighted average cost of capital, and g is the expected growth rate of free cash flow forever. Centre for Financial Management , Bangalore**VALUE DRIVER METHOD**This method too uses the growing free cash flow perpetuity formula but expresses it in terms of value drivers as follows: NOPLATT+1 (1 – g / r) CVT = (32.3) WACC – g where CVT is the continuing value at the end of year T, NOPLATT+1 is the expected net operating profits less adjusted tax for the first year after the explicit forecast period, WACC is the weighted average cost of capital, g is the constant growth rate of NOPLAT after the explicit forecast period, and r is the expected rate of return on net new investment. The formulae given in Eqns (32.2) and (32.3) produce the same result as they have the same denominator, and the numerator in Eqn (32.3) is a different way of expressing the free cash flow (the numerator of Eqn (32.2). Centre for Financial Management , Bangalore**REPLACEMENT COST METHOD**According to this method, the continuing value is equated with the expected replacement cost of the fixed assets of the company. This method suffers from two major limitations: (i) Only tangible assets can be replaced. The “organisational capital” (reputation of the company; brand image; relationships with suppliers, distributors, and customers; technical know-how; and so on) can only be valued with reference to the cash flows the firm generates in future, as it cannot be separated from the business as a going entity. Clearly, the replacement cost of tangible assets often grossly understates the value of the firm. (ii) It may simply be uneconomical for a firm to replace some of its assets. In such cases, their replacement cost exceeds their value to the business as a going concern. Centre for Financial Management , Bangalore