Corporate Valuation : An Introduction

1. Corporate Valuation : An Introduction Jayadev M June 7, 2019

2. Value is defining dimension of measurement Value is a measure of performance, it takes into account the long term interests of all the stakeholders in a company.

3. Importance of valuation Portfolio management: Fundamental analysts, active investors, Chartists, Information traders, market timers Analyst Recommendations: Stock brokers, Journalists and Analysts Acquisition and Divestures Corporate actions: Share buy back, stock options Legal and Tax purposes

4. Value creation: Core Principle Companies create value by investing capital they raise from investors to generate future cash flows at rates of return exceeding cost of capital. The faster companies can increasetheir revenues and deploy more capital at attractive rates of return, the more value create. Value creation means balancing near- term financial performance against what it takes to develop a healthy company that can create value for decades ahead – a demanding challenge.

5. The corollary is, any thing that doesn’t increase cashflows doesn’t create value. For example, share repurchases, substitution of debt with equity changes the ownership of claims to its cashflows. It doesn’t change the total available cashflows. Value is conserved but not created.

6. Valuation: Two Aspects Economics of Value Creation: How competitive advantage enables some companies to earn higher returns on invested capital than others Process of measuring value: Cash flows, growth rates, risk, cost of capital, comparable multiples, and various metrics

7. Market Efficiency: In an efficient market prices all the assets correctly Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. Evidence shows that Mutual fund investments, Analyst recommendations create value

8. Forgetting to Value Value: Lessons from History Rise and fall of business conglomerates' in 1970s Hostile takeovers in United States in 1980s Collapse of Japan’s bubble economy in 1990s South-East Asian Crisis in 1998 Internet Bubble 2001 Financial crisis 2008

9. Focus on Long Term Value: Benefits Companies dedicated to value creation are more robust and build stronger economies, higher living standards, and more opportunities for individuals Value creating companies also create more jobs Long term horizon with more investment in R&D Greater commitment to social responsibility

10. Value First, Valuation Process Follows Selection of projects/companies: Purpose, position Information collection What other analysts think about these companies Institutional factors: Incentive structure Inputs Post-valuation tinkering Qualitative factors

11. Sources of Uncertainty Estimation uncertainty: Impeccable information sources, converting raw information into inputs, selection of models Economic uncertainty: Markets and economies can change over time and even best models may not capture these. Micro uncertainty: Uncertainty about the potential market for a firm’s products, the competition it will face and the quality of its management team. Macro uncertainty reflects the reality that your firm’s fortunes can be affected by changes in the macro economic environment. Discrete uncertainty: Risks that lie dormant for periods but show up at points in time (Example: Pharma company approvals) Continuous uncertainty : Risk changes in interest rates or economic growth occur continuously and affect value as they happen

12. Responses of Uncertainty Better valuation models Valuation ranges; usage of simulations or best case and worst case Probabilistic statements

13. What to do about uncertainty Analysts should concentrate on building the best models they can with as much information as they can legally access. Analysts have to give reasonable margins for error in making recommendations on the basis of valuations. Valuation can not be judged by its precision Complexity of information Cost of complexity; Information overloaded, Black box syndrome “ The model valued the company at $30 per share” The Principle of Parsimony

14. Approaches Asset valuation Intrinsic value/DCF value Relative valuation Contingent claims

15. Asset Based Valuation approaches Book value Adjusted book value Replacement value Liquidation value

16. Approaches to Valuation DCF valuation • Expected cash Flows • Expected Growth • Discount rates • NPV and APV • Going concern and Asset valuation • Equity valuation and Firm valuation

17. Approaches to Valuation Relative Valuation Comparable or similar asset Standardized price Direct comparison Peer group average Peer group average adjusted for differences Income statement approach Multiples Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected.

18. There are two ways to look at valuations. Valuations cannot be looked at in the context of the absolute relative valuation or an absolute Price-Earnings (P/E) based or Price to book metric. What we have seen in the last 12 months is two factors. One is the whole deluge of liquidity that …… and secondly, the decline in cost of capital…. So that the cost of capital decline has helped the valuation at the margin. ……we are looking at a trailing P/E of around 22.5-23 times and may be a forward P/E of somewhere 20-20.5,GautamDuggad,HeadMotilalOswal Securities, Live Mint, September 4, 2017

19. Intelligent and sophisticated value investors—in the mould of Buffett and Munger—who buy fundamentally strong companies at a discount to their intrinsic value, look at the whole scenario and have no implicit assumptions. They verify the conservative intrinsic value of the company based on its proven fundamentals and whether the company is available at a significant discount to this, i.e., has a huge margin of safety. The best investment results come from investors who buy growth companies at a discount to their intrinsic value. Munger, Buffett, Peter Lynch and Philip Fisher are some of them. Vikas Gupta executive vice-president—traded markets and investment research, ArthVeda Fund Management Pvt. Ltd.(Source: Live Mint, First Published: Wed, Aug 10 2016)

20. Contingent claim valuation Real options have a substantive appeal as they add managerial flexibility to the decision-making process. While the value of real options increases tremendously during volatile times, it is also a strong tool whenever we feel we have the flexibility to refocus our strategy, based on new information. During Tata Tea Ltd’s acquisition of Tetley in 2000, a part of the value of the transaction was the option value of acquiring a well-known brand-GovindSankaranarayananis CFO, Tata Capital Ltd, December 18,2008 An asset that pays off only under certain contingencies Equity in a company Natural resources owned by a company (Coal,Gas etc..) A company’s patent right

21. Complexity Intimidation Biases and Pre-conceptions Valuation Principles DCF,APV, Cost of capital Uncertainty Assumptions on growth rates

22. Course outline

23. Our focus is on… Understanding cash flows and accounting adjustments Projecting cash flows Cost of capital Enterprise valuation Valuation of Equity Valuation by multiples Valuation of contractual options Evaluating strategic opportunities

24. Across different types of businesses Listed companies Unlisted companies Manufacturing, trading, service companies Financial services companies Intangibles Venture capital and private equity Strategic opportunities

25. Getting ready for class Accounting Statistics Finance

26. Evaluation • Class Assignments and Participation: 25% • One test: 45% • Project report : 30% • Valuation team (25%) and Due diligence team (5%) • Pick-up some trouble some company • Manufacturing and service companies • Focus on other markets also

27. Books Investment Valuation, AswathDamodaran, Third edition Damodaran on Valuation - 2nd Edition (http://pages.stern.nyu.edu/~adamodar/New_Home_Page/dam2ed.htm) Valuation: Mergers, Buyouts and Restructuring 2nd Edition,  Enrique R. Arzac Valuation: Measuring and Managing Value of Companies (5th edition/6th edition), Mckinsey and Company (http://www.gsm.pku.edu.cn/resource/uploadfiles/docs/20120710/2012071001255625564651.pdf)