Objectives

To understand the various approaches to valuation

What is the need for business valuation?

Product Price Company Price

What is the need for business valuation?

Product Price Company Price

Business Valuation

BUSINESS VALUTION
Conceptual Framework of Valuation

Approaches/Methods of Valuation Other Approaches to Value Measurement

Solved Problems
Mini Case

CONCEPTUAL FRAMEWORK OF VALUATION

The term valuation implies the estimated worth of an asset or a security or a business. The alternative approaches to value a firm/an asset are: Book value, Market value, Intrinsic value, Liquidation value, Replacement value, Salvage value Fair value.

Book Value
The book value of an asset refers to the amount at which an asset is shown in the balance sheet of a firm.
Book value = Initial acquisition cost accumulated depreciation

Book Value
Book value of a business refers to total book value of all valuable assets (excluding fictitious assets, such as accumulated losses and deferred revenue expenditures, like advertisement, preliminary expenses, cost of issue of securities not written off) less all external liabilities (including preference share capital).

Market value
Market value refers to the price at which an asset can be sold in the market. The market value can be applied with respect to tangible assets only; intangible assets (in isolation), more often than not, do not have any sale value. Market value of a business refers to the aggregate market value (as per stock market quotation) of all equity shares outstanding. The market value is relevant to listed companies only.

Intrinsic/Economic Value
Intrinsic/Economic Value is the present value of expected future cash inflows using an appropriate discount rate.

t = n CF t Value = t t =1 (1+ r)

Liquidation Value
liquidation value represents the price at which each individual asset can be sold if business operations are discontinued in the wake of liquidation of the firm In operational terms, the liquidation value of a business is equal to the sum of (i) realisable value of assets and (ii) cash and bank balances minus the payments required to discharge all external liabilities. In general, among all measures of value, the liquidation value of an asset/or business is likely to be the least.

Replacement Value
The replacement value is the cost of acquiring a new asset of equal utility and usefulness. It is normally useful in valuing tangible assets such as office equipment and furniture and fixtures, which do not contribute towards the revenue of the business firm.

Salvage Value
Salvage value represents realisable/scrap value on the disposal of assets after the expiry of their economic useful life. It may be employed to value assets such as plant and machinery. Salvage value should be considered net of removal costs.

Fair Value
Fair value is the average of book value, market value and intrinsic value In India, the concept of fair value has evolved from case laws (and hence is more statutory in nature) and is applicable to certain specific transactions, like payment to minority shareholders

What is Valuation ?

Knowing the value of an asset and what determines the value,

in choosing investment for a portfolio in restructuring corporations in deciding on the appropriate price to pay or receive in takeover A postulate of sound investing is that an investor does not pay more for an asset than it is worth

Valuation methods
Income approaches Asset approaches Market approaches

Fair value Method

Asset-Based Approach to Valuation

Assets-based method focuses on determining the value of
Net assets = (Total assets Total external obligations) (1)

Net assets per share can be obtained dividing total net assets by the number of equity shares outstanding. It indicates the net assets backing per equity share (also known as net worth per share). Net assets per share = Net assets / Number of equity shares issued and outstanding (2)

Example 1: Following is the balance sheet of Hypothetical Company Limited as on March 31, current year. Share capital 40,000 11% Preference shares of Rs 100 each, fully paid-up 1,20,000 Equity shares of Rs 100 each, fully paid-up Profit and loss account 10% Debentures Trade creditors Provision for income tax Fixed assets Less: Depreciation Current assets: Stocks Debtors Cash at bank Preliminary expenses Rs 150 30 100 50 10 120

40

120 23 20 71 8 282

160 2 ____ 282

Additional Information: (i) A firm of professional valuers has provided the following market estimates of its various assets: fixed assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45 lakh. All other assets are to be taken at their balance sheet values. (ii) The company is yet to declare and pay dividend on preference shares. (iii) The valuers also estimate the current sale proceeds of the firms assets, in the event of its liquidation: fixed assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40 lakh. Besides, the firm is to incur Rs 15 lakh as liquidation costs. You are required to compute the net asset value per share as per book value, market value and liquidation value bases.

Book Value Method

Solution : Determination of Net Asset Value per Share (i) Book value basis Fixed assets (net) Current assets: Stock Debtors Cash and bank Total assets Less: External liabilities: 10% Debentures Trade creditors Provision for taxation 11% Preference share capital Dividend on preference shares (0.11 Rs 40 lakh) Net assets available for equityholders Divided by the number of equity shares (in lakh) (Rs lakh) Rs 120 Rs 100 50 10

160 280

20 71 8 40 4.4 143.4 136.6 1.2 113.83

(ii) Market value basis

130

Fixed assets (net)

Current assets: Stock Debtors Cash and bank Total assets Less: External liabilities (as per details given above): 102 45 10 157 287 143.4 143.6

Net assets available for equityholders

Divided by the number of equity shares (in lakh) Net assets value per equity share (Rs)

1.2
119.67

(iii) Liquidation value basis

105

Fixed assets (net)

Current assets: Stock 90

Debtors
Cash and bank Total assets

40
10 140 245

Less: External liabilities (listed above):

Less: Liquidation costs Net assets available for equityholders Divided by the number of equity shares (in lakh) Net assets value per equity share (in Rs)

143.4
15.0 86.6 1.2 72.17

Income approaches

The value of an company is looked at in terms of the present value of its future cash flows

Asset approaches

The value of a business is equal to the sum of its parts The value depends on the net book value of assets Adjusted for fair market value wherever applicable. This method is not a probative method for on going business, it can assess the value of intangibles like good will. Value is arrived by looking at the market price of Similar assets. Buyers would not pay more for an item than the Price at which they can obtain an equally desirable substitute.

Market approaches

Famous 5 business valuation Myths

1. Valuing a business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process. Business in my industry always sell for two times annual revenue. So why should I pay someone to value my business? A local competitor sold his business for 3 times revenue six months ago. My business is worth at least this much.

2.

3.

4. How much a business is worth depends on what the valuation is used for 5. Your business loses money, so it is not worth much.

What are the uses of various approaches to valuation ?

IT

Old Economy

Banks

Service Firms

Approaches to Valuation

APPROACHES TO VALUATION Four approaches to valuation

Asset based valuation
Determining the valuation of a business based on the book value of the assets.

Discount cash flow valuation

Relates the value of an asset to the present value of expected future cash flows on that asset

Relative valuation
Estimates the value of an asset by looking at the price of comparable assets

Contingent claim valuation

Uses option pricing models to measure the value of assets that share option characteristics

Approaches to Valuation
Valuation Models
Asset Based Valuation Discounted Cashf low Models Relative Valuation Contingent Claim Models

Liquidation Value
Stable Current

Equity
Firm

Sec tor

Option to delay

Option to expand Young firms

Option to liquidate Equity in troubled firm

Market

Replac ement Cost

Tw o-s tage
Three-stage or n-stage

Normalized

Earnings Book Revenues Value

Sec tor specific

Undeveloped land

Equity Valuation Models

Dividends

Firm Valuation Models

Patent Undeveloped Res erves

Free Cashflow to Firm

Cost of capital approach

APV approach

Excess Return Models

Asset based Valuation Methods

Book value Method

Market Value Method

Replacement Cost

Liquidation value

Replacement Value

Replacement value is the potential amount that one will have to spend at current rates to replace the existing assets of a company.

Replacement Cost S.no 1 2 3 4 5 6 Company India cements Madras cement Tata Steel Hindalco JSW Energy JP Associates Adjusted replacement cost (FY 12) in crores 7600 6800 1,21,000 52,000 15,900 30,400 Adjusted replacement cost (FY 15) in crores 44,700 10,800 9,900 19,000 1,79,600 60,000 19,400 23,200 6200 16,100 17,600 44,100 9000 Market Cap 2460 3613 40,669 23,445 8011 14,683 Potential upside % 208.9 88.2 197.5 121.8 98.5 107

S.no 1 2 3 4 5 6 7 8 9 10 11 12 13

Company Grasim India Cements Madras Cement Shree cement Tata Steel Hindalco JSW Energy JP Power Ventures Phoenix Mills Jaypee Infratech GMR Infra JP associates IRB Infrastructure

Market Cap 22,438 2,460 3,613 9,197 40,669 23,445 8011 9,252 2560 6375 8699 14,683 3938

Potential upside % 99.2 339 174 106.6 341.6 155.9 142.2 150.8 142.2 152.5 102.3 200.3 128.5

OPTIONS

Obligation Vs Option

Real Option Valuation Models

Spice Jet
Low-cost carrier (LCC) SpiceJet said it would spend $900 million to buy 30 small aircraft from Canada Bombardier to enhance regional connectivity in the country. India has about 90 airports in tier-II and we plan to enter these areas, as there are no LCCs here The Q400 NextGen turboprop aircraft from Bombardier can seat 78 passengers and has low noise and vibrationfree features. It uses up to 40 per cent less fuel than the regional jet aircraft

SpiceJet has also ordered 30 Boeing aircraft and deliveries of the same would begin by 2013

Assets
Existin g Investmen ts Generate cas hflow s tod ay In clu des long lived (fixed ) and sh ort-liv ed(working capital) ass ets Expected Value that will be created by future investments Ass ets in Place Debt

Liabilities
Fixed Claim on cas h flo ws Little o r No role in management Fixed Ma turity Tax Dedu ctible

Grow th As sets

Equity

Res idu al Claim on cas h flow s Significan t Role in management Perpetual Lives

Pfizer

Phases of development

Rotten tomatoes tomatoes Never Take Region 6

Ripe tomatoes Take now Region 1

Late blossoms and Small Green tomatoes Probably never (Region 5)

Imperfect but edible Tomatoes May be now (Region 2)

Less Promising Green tomatoes May be later (Region 4)

Inedible, but very Promising tomatoes Probably later (Region 3)

Value to cost 0
1
Region 6 invest never Region 1 Invest now Region 2 may be now Projects here have an NPV >0 even if exercised immediately

Lower

Region 5 Probably never

volatility

Region 4 May be later

Higher

Region 3 probably later Projects here have an NPV <0, but a value to cost metric greater than one makes them promising.

TEACHING METHODOLOGY

Concepts
Guiding principles Tools and Techniques Exercise

Discount Cash Flow Technique

Basis for all valuation approaches

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

Discounted Cash Flow Valuation

What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Information Needed: To use discounted cash flow valuation, you need to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value

Discounted Cash Flow Valuation

Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

Discounted Cashflow Valuation: Basis for Approach

t = n CF t Value = t t = 1 (1 + r)

Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset.

Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

What is the use of DCF valuation?

Estimating Merger Gains and Costs
Suppose that you are the finance manager of firm A and you want of analyze the possible purchase of firm B. What is the first thing you look for ? Is there any economic gain from merger ?
Economic gain arises only if the two firms are worth more together than apart

How do you calculate economic gain?

Gain = PVAB - ( PVA + PVB ) =

PVAB

Cost of acquiring B
Cost = Cash paid - PVB

Net Present value = Gain - Cost

=

PVAB - ( Cash paid - PVB )

NPV = wealth with merger - wealth without merger

How do you calculate economic gain?

Firm A has a value of Rs 200 million and B has a value of Rs 50 million. Merging the two would allow cost savings with a present value of Rs 25 million. Calculate the (NPV)Economic gain from the merger.Assume firm B is bought for cash Rs 65 million.

Value of a firm

Equity investors

All investors (Equity & Debt)

Cash Flows to Equity

Cash flows to Firm

 Delhi International Airport GMR group: 54 % AAI: 26 % Malaysia Airports Holdings: 10 % Fraport: 10 %

Mumbai International Airport Ltd

GVK Group: 50.5 % AAI : 26 % BSD (Mauritius): 13.5 % ACSA Global: 10 %

Pantaloon Retail

Promotors 41.84% 46.57% Institutions Non Institutions 11.59%

Discounted Cash Flow Valuation

Equity Valuation

Firm valuation

Cash flows to equity Discount rate (cost of equity)

Cash flows to firm Discount rate (WACC)

I.Equity Valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments and reinvestment needs, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
0 1 FCFE1 2 FCFE2 3 FCFE3
t=n

4 FCFE4

5 FCFE5

n FCFEn

Value of Equity =

where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity

CF to Equity t (1+ k )t t=1 e

II. Firm Valuation

Cost of capital approach: The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.
0 1 2 3 4 5 n

FCFF1

FCFF2

FCFF3
t= n

FCFF4

FCFF5

FCFFn

Value of Firm =

CF to Firmt t t =1 (1+ WACC)

Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION
Expe cte d Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Firm is in stable growth: Grows at con stant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Fore ver

Le ngth of Pe riod of High Growth

Disc ount Rate Firm:Cost of Capital Equity: Cost of Equity

 Assume that you are analyzing a company with the following cash flows for the next five years. Assume also that the cost of equity is 13.625 % and that the firm can borrow long term at 10 % ( The tax rate for the firm is 50 % ) The current market value of equity is Rs 1073 and the value of debt outstanding is Rs 800 year CF to equity interest (1-t) CF to firm 1 50 40 90 2 60 40 100 3 68 40 108 4 76.20 40 116.20 5 83.49 40 123.49 Ter Val 1603 2363 Calculate the value of the firm using Equity valuation and Firm valuation approaches.

Example 4 Suppose a firm has employed a total capital of Rs 1,000 lakh (provided equally by 10 per cent debt and 5 lakh equity shares of Rs 100 each), its cost of equity is 14 per cent and it is subject to corporate tax rate of 40 per cent. The projected free cash flows to all investors of the firm for 5 years are give in the table:

Year-end 1 2 3 4 5

Rs 300 lakh 200 500 150 600

Compute

(i) valuation of firm and (ii) valuation from the perspective of equityholders. Assume 10 per cent debt is repayable at the year-end 5 and interest is paid at each year-end.

Solution : (i) Computation of Overall Cost of Capital Source of capital Equity Debt Weighted average cost of capital (k0) After tax cost (%) 14 6* Weights 0.5 0.5 Total cost (%) 7 3 __ 10

* 10% (1 0.4 tax rate) = 6 per cent

(ii) Valuation of Firm, Based on K0 Year-end 1 2 3 4 5 Total present value/valuation of firm Less value of debt Value of equity FCFF Rs 300 200 500 150 600 PV factor (0.10) 0.909 0.826 0.751 0.683 0.621 Total present value Rs 272.70 165.20 375.50 102.45 372.60 1,288.45 500.00 788.45

(iii) Valuation of Equity, Based on Ke Year-end FCFF to all investors After tax payment to debtholders Rs 30* 30 30 30 530** FCFE to equityholder s PV factor (0.14) Total present value

1 2 3 4 5 Total present value

Rs 300 200 500 150 600

Rs 270 170 470 120 70

0.877 0.769 0.675 0.592 0.519

Rs 236.79 130.73 317.25 71.04 36.33 792.14

* Interest on Rs 500 lakh @ 10% = Rs 50 lakh; Rs 50 lakh (1 0.4) = Rs 30 lakh

** Inclusive of debt repayment of Rs 500 lakh at year-end 5.