CHAPTER 1
AN OVERVIEW
Outline
Concept of Fair Value
Context of Valuation
Approaches to Valuation
Features of the Valuation Process
Corporate Valuation in Practice
Importance of Knowing Intrinsic Value
Goal of Valuation
…… Fair market value … company …. Price …
….. Willing buyer … seller …. No compulsion …
reasonably knowledgeable
Intrinsic Value
Warren Buffett : “Intrinsic value is an all important concept
that offers the only logical approach to evaluating the
relative attractiveness of investments and businesses.
Intrinsic value can be defined simply : It is the discounted
value of the cash that can be taken out of a business during
its remaining life”
. CASH FLOW
. TIMING
. DISCOUNT RATE
Valuation
.
Bond
Stock
Derivative I
VALUATION Project
Strategy
Division
Company
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
Context of Valuation
Raising capital for a nascent venture
Initial public offering
Acquisitions
Divestitures
PSU disinvestment
ESOPs
CONTEXT OF VALUATION
• MERGER
SUN - RANBAXY EXCHANGE RATIO ?
• TAKEOVER
HINDALCO - INDAL PRICE FOR CONTROLLING BLOCK
TATA STEEL- CORUS
• TRANSFER OF A BLOCK OF SHARES
GRASIM - L&T PRICE FOR 10% BLOCK
• PURCHASE OF PLANT/ DIVISION
SRF … NYLON TYRE
CORD DIVISION OF CEAT PRICE FOR A DIVISION ?
• PSU DIVESTMENT
IPCL PRICE FOR PARTIAL DIVESTMENT
• IPO-- OFS PRICE … IPO /OFS?
• REVALUATION REVALUED FIGURE
•BUYBACK Piramal Healthcare
Approaches to
Valuation
Stock and Relative Option
Book Value DCF
Debt Valuation Valuation
Approach Approach
Approach Approach Approach
PROJECT COMPANY
· FINITE LIFE · INDEFINITE
(INFINITE) LIFE
· ONE - OFF · GROWING ENTITY
INVESTMENT … CONTINUING
INVESTMENT
Project Valuation
Costs and Benefits
Cost of Capital
NPV and IRR
SEPARATION PRINCIPLE
PROJECT
FINANCING INVESTMENT
0 + 100 0 - 100
1 1
- 114 + 120
PROJECT CASH FLOWS
(RS. IN MILLION)
0 1 2 3 4 5
A. FIXED ASSETS (80.00)
B. NET WORKING CAPITAL (20.00)
C. REVENUES 120 120 120 120 120
D. COST (OTHER THAN DEPR’N AND INT) 80 80 80 80 80
E. DEPRECIATION 20 15 11.25 8.44 6.33
F. PBIT 20 25 28.75 31.56 33.67
G. TAX 6 7.5 8.63 9.47 10.10
H. NOPAT 14.0 17.5 20.12 22.09 23.57
I. NET SALVAGE VALUE OF FIXED ASSETS 30.00
J. RECOVERY OF NET WORKING CAPITAL 20.00
K. INITIAL OUTLAY (100.00)
L. OPERATING CASH FLOW (H+E) 34.0 32.5 31.37 30.53 29.90
M. TERMINAL CASH FLOW (I+J) 50.0
N. NET CASH FLOW (K+L+M) (100.00) 34.0 32.5 31.37 30.53 79.90
BOOK VALUE OF INVESTMENT 100 80 65 53.75 45.31
STEPS IN DCF APPROACH
1. FORECAST THE CASH FLOW DURING THE EXPLICIT FORECAST PERIOD
2. ESTABLISH THE COST OF CAPITAL
3. DETERMINE THE CONTINUING VALUE
4. CALCULATE THE FIRM VALUE
DCF VALUATION
1 2 3 4 5 6 7
INV. CAP (BEG) 50.0 60.0 72.0 86.4 96.77 108.38 117.05
NOPAT 6.0 7.2 8.64 10.37 11.61 13.00 14.05
NET INV( D NCA + DNFA) 10.0 12.0 14.4 10.37 11.61 8.67 9.36
FCF (4.0) (4.8) (5.76) - - 4.33 4.69
GROWTH RATE 20 20 20 12 12 8 8
- 4.0 -4.8 -5.76 0 0 4.33
PV (FCF) = + + + + + = -9.53
(1.11) (1.11) 2
( 1.11) 3
(1.11) 4
(1.11) 5
(1.11) 6
4.69 1
PV (CV) = x = 83.58
0.11- 0.08 (1.11) 6
VO = -9.53 + 83.58 = 74.05
ZEN OF CORPORATE FINANCE
The horizon value (or continuing) value of the firm looms large in most
valuation exercises. Dropping the subscripts, for the sake of simplicity, we
get:
FCF
V = ………….. (1)
WACC- g
FCF, the numerator on the RHS of the above equation, may be expressed as
follows:
FCF = NOPAT – NI
NI
= NOPAT 1 –
NOPAT
NI/IC
= NOPAT 1 –
NOPAT/IC
g
= IC x ROIC 1 – (2)
ROIC
Hence, eq. (2) may be expressed as :
g
IC x ROIC 1 –
ROIC
V= (3)
WACC- g
KEY DETERMINANTS OF VALUE
VALUE= f( INVESTED CAPITAL,
RETURN ON INVESTED CAPITAL,
GROWTH RATE,
WACC)
DCF VALUATION MODELS
• Enterprise DCF Model
• Equity DCF model
Dividend discount model
FCFE model
• Adjusted present value model
• Economic profit model
INFORMATION NEEDED FOR
VALUATION
A. Industry and Competition
B.Operations
C.Marketing and Sales
D.Human Resources
E.Historical Financial Information
F. Financial Projections
Features of the Valuation Process
Bias in Valuation
. Choice of Company
. Market Value
. Institutional Pressures
Manifestation of Bias
. Optimistic or Pessimistic Definition of
Inputs.
. Post-valuation Tinkering.
contd..
Mitigation of Bias
. Avoid Precommitments.
. Delink Valuation from
Reward/Punishment.
. Diminish Institutional Pressures.
. Increase Self-Awareness.
Uncertainty in Valuation
. Estimation Uncertainty
. Firm specific Uncertainty
. Macroeconomic Uncertainty
Response to Uncertainties
. Better Valuation Models
. Valuation Ranges
. Probabilistic Estimates
Corporate Valuation in Practice
Relative Valuation
Transaction Multiples
DCF Valuation
Common Practice
. IPO Relative Valuation
. M&A : . DCF Valuation
. Transaction Multiples
. Hybrid Model
. M&A .. Financial Buyer
. DCF Valuation with primary focus on IRR
REFINEMENTS IN VALUATION
The disappointing outcomes of mergers and acquisitions
of 1980s have led to refinement in company valuation.
Thanks to the magic of Internet, now public filings are
available online. Further, organizations like Factset and
Ibbotson Associates provide a constant flow of data on
M&A transactions and cost of capital statistics.
If the valuation methodology has improved so much,
why do companies overpay so often even now. One
reason is the imprecision in estimating synergies.
Another reason is that the numbers can be tweaked to
justify the deal the CEO wants to do regardless of price.
As Thomas Lys of Kellogg School of Management said,
“Valuation is just an excuse. The moment it becomes
clear that the CEO wants to do the deal no matter what,
his investment banker and advisers are ‘best advised to
tell the emperor that his clothes are beautiful.’”
JUDICIAL REVIEW AND REGULATORY
OVERSIGHT ON VALUATION
Valuation is understandably the most contentious issue
in various corporate transactions such as mergers,
takeovers, preferential allotments by listed companies,
and so on. Hence it is subject to regulation and judicial
review in various ways. Here is a synoptic view of such
regulation and review.
• The pricing of preferential allotments by listed
companies is subject to regulations of SEBI.
• To determine the fair value of shares to be transferred
by a resident in India to a non-resident, the RBI has
prescribed that the DCF method must be used and the
valuation must be done by a chartered accountant or a
SEBI-registered category 1 merchant banker.
• The pricing of open offers under the SEBI Takeover
Code is subject to regulation.
• The valuation in a merger petition submitted to the
court is a matter of judicial review.
• Minority shareholders, creditors, the central
government, SEBI, or revenue authorities can challenge
the proposed valuation in a court of competent
jurisdiction for judicial review.
In general, the courts have maintained that valuation is
a technical exercise to be done by experts and that
courts will interfere only when it is seriously flawed or
unfair.
INTRINSIC VALUE AND THE STOCK
MARKET
• For short periods, market values may diverge from
fundamental values, but in the long run there is a
remarkable convergence between the two
• Return on invested capital (ROIC) and growth are the
major drivers of value
• Markets reflects substance, not form
• Emotions and mispricing
A MODEL OF THE MARKET
• A simple and yet insightful model assumes that two
types of investors trade in the market viz., informed
investors and noise traders
• Informed investors estimate intrinsic value based on
fundamental analysis. Noise traders trade on the
basis of some new that may not really be material.
• As a result of the interaction among these players,
market prices tend to gyrate around intrinsic value
MODEL OF THE STOCK MARKET
Price Behaviour
Importance of Knowing Intrinsic Value
Although valuations have been wrong from time to time, eventually
they have returned to the level justified by economic fundamentals.
Such market deviations suggest that it is even more important for the
managers of a company to understand and focus on the intrinsic value
of its shares.
Managers can exploit such deviations by:
. Issuing additional share capital when the share price is too high
relative to its intrinsic value.
. Buying back shares when the share price is significantly
less than its intrinsic value.
. Paying for acquisitions with shares instead of cash when the
share is overvalued.
. Divesting particular businesses when the trading multiples are
higher than what can be justified by the fundamentals.
CONSEQUENCES OF IGNORING VALUE
Ignoring intrinsic value can have serious adverse
consequences, as the following conspicuous examples
suggest:
• The rise and fall of business conglomerates in the
1970s.
• Hostile takeovers in the US in the 1980s.
• The collapse of Japan’s bubble economy in the
1990s.
• The Southeast Asian crisis in 1998.
• Internet bubble
• The economic crisis starting in 2007.
• The ambitious global leveraged acquisitions by Indian
firms.
Summary
Since value maximisation is the central theme in financial management, all managers must
understand what determines value and how value should be measured.
The fair market value of a company is the price at which it would change hands between a
willing buyer and a willing seller when the former is not under any compulsion to buy and
latter is not under any compulsion to sell, both parties having reasonable knowledge of
relevant facts.
Inter alia, corporate valuation is done in the following situations: raising capital for a
nascent venture from a venture capitalist or private equity investor, initial public offering,
acquisitions (takeovers, mergers, and purchases of divisions), divestitures, PSU
disinvestments, and employee stock options plans.
There are five broad approaches to appraising the value of a company: book value
approach, stock and debt approach, discounted cash flow approach, relative valuation
approach, and option valuation approach.
Valuation is often characterised by bias stemming from factors like perception about the
company being valued, the current market value of the company, and institutional
pressures.
To mitigate the bias in valuation avoid precommitments, delink valuation from reward or
punishment, diminish institutional pressures, and increase self-awareness.
In general, there is always an uncertainty associated with valuation on account of
estimation uncertainty, firm-specific uncertainty, and macroeconomic uncertainty.
Very broadly, the investment banking industry employs three basic methodologies for
enterprise valuation: relative valuation, transaction multiples, and discounted cash flow
valuation.
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