assocham valuation

Valuation for merger and acquisition

March 2015

Flow of presentation

Valuation methodologies

Valuation in the context of Merger and Acquisition

Indian Regulatory Environment and Minority Interest Safeguard

Valuation methodologies

Valuation methodologies Business / Share

Applicability of a particular methodology guided by:Nature of industryStage of company (nascent / growth or mature)Listed / unlisted In case of listed, whether frequently traded or not

Book Value

Replacement Cost

Cash flow based Market based

Quoted Market Price

Comparable Listed Multiples

Comparable Transaction Multiples

Discounted Cash Flow Free cash flow to

firm (FCFF) Free cash flow to

equity (FCFE)

Asset based

Generally Not Suitable for Fair Valuation of Going Concerns

Fixed Assets Revalued or Book Value?

Current Assets - Cost or Realizable Value

Differences in Accounting Policies in case of Merger or Relative Valuations

Adjustments for Contingent Liabilities

Issues Involved

Fails to factor the value of intangible assets like brands, technical know-how, distribution network etc.

Impacted by accounting

Assumes assets always have profit generating value

Ignores Returns vs. Cost of capital

Limitations

Arrives at valuation of an entity in terms of Tangible Net Worth of the entity as at valuation date

Asset Based Methodologies- Net Assets/ Replacement Value

Is NAV completely doomed?

Not really

A Loss-making Company

Any CompanyFacing Potential

Liquidation

A Real-EstateCompany

A Company Making Inadequate Return

on Capital

Methodology involves three elements: assessment of maintainable earnings application of an appropriate multiple of comparable companies identification and valuation of any surplus assets or liabilities

Comparable Companies Global vs. Indian comparisons Identifying direct comparables: Research on companies is the key Accounting for size differentials Accounting for differing operating conditions

Choice of multiples Transaction vs. Stock Market Multiples Sales vs. Profitability Multiples Vs. Capacity Multiples Historical vs. Forward Multiples

Valuers judgment required for appropriate choice

Comparable Multiple Method

Choice of multiples

Sector Multiple Used Rationale

Manufacturing EV/EBITDA Often with normalized earnings

Growth firms PEG ratio Big differences in growth rates

Young growth firms with losses Revenue Multiples What choice do you have?

InfrastructureEV/EBITDA, Price/ Book equity depending on industry and capital structure

EV/EBITDA - Normalized profits can be reasonably determined;P/BV Since most of them are capital intensive

Financial Services Price/ Book equity Marked to market

Retailing Revenue multiples Margins equalize sooner or later

Oil &Gas, Mining Resource multiples (EV/resource) Cash flows are directly related to resources

Choice of multiple depends on the sector in which the Company operates

Identifying Comparable Set of Companies

Difference in Size, Margins, Operating Efficiencies

Differences in Accounting Policies/ Leveraging Risks

Issues Involved

Markets may not necessarilyvalue companies fairly at allpoints of time

Adequate and reliable details fortransaction multiples notavailable in most of the cases

Limitations

Comparable Multiple Method

Provides a good benchmark to test reasonableness

Considered to be the most logical method of valuation

Determines the net present value of underlying cash flows of the business

Not Impacted by accounting principles, as based on cash flows and not book profits

Incorporates all factors relevant to business e.g.

Tangible and intangible assets

Current and future competitive position

Financial and business risks

Business Value = NPV (FCFs) = NPV (NOPLAT Incremental WC Incremental Capex)

Discounted Cash Flow (DCF) Method

Equity versus firm

Equity valuation Values the claims of the equity shareholders on the business Operating cashflows are considered and adjusted for movements in debt (debt

taken, repaid and interest) Discount rate used should only be the cost of equity capital Appropriate when the company has stable leverage

Firm valuation Values the claims of the all the stakeholders (debt and equity) on the business Operating cashflows are considered but movements in debt (debt taken, repaid

and interest) are not taken into consideration Discount rate used should only be the weighted average cost of capital (equity +

debt) Appropriate when the company has unstable leverage

DCF Method Some key points

Valuation is at a particular date- the valuation date Preferably the date nearer to the date of the valuation workings

Cash Inflows Remember to take out non- operating cash flows Non operating cash flows are best valued as surplus asset (discussed later) Examples Interest on surplus funds, dividends, profit on sale of fixed assets

investments, liability write offs

DCF Method Some key points.. Contd.

Cash Outflows Incremental working capital aligned with sales growth

Working capital improvements are possible, but difficult Especially without margin adjustments

Extremely important matter for high working capital companies Sugar seasonal variations. Does EV include working capital?

Capital Expenditure Incremental for Growth Dont underestimate maintenance capex

May not be immediate Gross Asset value/ Asset life is a broad benchmark. However, cannot ignore technological

obsolescence

Income tax Is on PBIT (because WACC assumes post tax debt cost) Actual rate for explicit period; Adjusted for future Stretch explicit period till exemption periods are over; Or value tax benefits

separately

Discounting rate WACC

The Rate of Return that an Investor would require to be induced to invest in the stream of future cash flows being discounted

Weighted Average Cost of Capital

= Re X (E/(D+E)) + Rd x (1-t) X (D/(D+E))

Cost of Debt Weighted average cost of debt

The Debt- Equity weights are market based and not book based One of the most important causes for Over valuation

Weighted average Cost of Capital (WACC)

Some key points

Discount rate used should be consistent with both the riskiness andthe type of cashflow being discounted. Equity versus Firm: cash flows to equity should be discounted with cost of

equity. Cash flows to the firm should be discounted with the cost of capital. Currency: The currency in which the cash flows are estimated should also

be the currency in which the discount rate is estimated- USD discount ratecan not be used for rupee cash flows or vice versa

Nominal versus Real: For real cash flows (i.e., excluding inflation), thediscount rate should be real

More logical to use mid year discount rate

Perpetuity Value/ Terminal Value

Perpetuity value is the projected value of the business at the end of the outlook period

It represents a means of obtaining a proxy for the value of the future cash flows of the business after the end of the outlook period

Common Approaches to Perpetuity Value

Cash Flow approach (Gordon Growth method)Take forecast net cash flow for the last year of the outlook periodDivide above amount by r-gr = Discount rate to be utilizedg = Long term forecast average annual rate of growth after outlook period

Capitalization of earnings/Exit multiple approachEstimate future maintainable annual EBITDA after the outlook periodSelect an appropriate EBITDA multiple to apply to those earnings

Adjustment for surplus assets and contingent liabilities Surplus assets Key characteristics

Not used for generation of profitability

Purchased out of past cash flows

Usually land/ properties/ investments

Be careful to separate surplus cash from operating cash

When an asset is surplus, any return generated by it should not be included in operating cash flows

Contingent liabilities Usually tax cases Good idea to take expert advice

DCF : Strengths and Limitations

Theoretically correct

Forward looking

Incorporates risk and time value of money

Focuses on cash returns

Volume and complexity of assumptions

Adequacy of data

At times, extremely sensitive to small changes in assumptions

Developing an understanding of the business is the key to a good DCF

LimitationsStrengths

Valuation, Really a Call on Three factors..

Growth How Much? How

Sustainable? How Long?

Risk

External/Internal Price Risk

Manageable/ Non manageable

Mitigating Factors Brand, Distribution

Value

Management Quality

Reputation, Competence, Vision, Corporate Governance

Premium to HDFC Bank

Valuation in the context of Merger and Acquisition

Merger and Acquisition- Situations

Merger/DemergerMerger

involves absorption of one company by another or amalgamation of two companies to form a new company

Consolidation of businesses / entities to take synergy benefits

Demerger

involves transfer of identified business from one company to another

Vertical split of the company usually for Inviting investor in identified business

Acquisition Business purchase slump sale/itemized sale Usually for expansion of existing business

Share purchase Focus on inorganic growth /strategic or non strategic investments

Valuation for merger and acquisition

Mergers Relative value of their shares - rather than absolute value. Value is determined -

on going concern basis on as is where is basis post merger synergies/benefits not to be considered

Demerger Usually not required when demerged into wholly owned subsidiary/ company with

mirror shareholding But if the demerger is into an existing operating entity, valuation is required

Acquisitions Absolute valuation of shares- not relative valuation Value is determined - on going concern basis post merger synergies/benefits are considered

Swap ratio for merger / demerger

Since scheme of arrangement is filed in a court of law, it is generally accepted to also give weight to NAV method even though it may not be the most appropriate method Supreme court HLL case (HLL and TOMCO merger) Combination of three methods - NAV, Market Price and Earnings Capitalization

(comparable multiples) Weights to different methods: NAV : 20% Market price : 40% Earnings : 40%

However, these are not definitive and may be modified, depending upon the facts and circumstances of each case. However, weights given should be explained and justified

SEBI Fairness Opinion from Category 1 Merchant Banker

Acquisition valuations can depart from fair values ..

Same target can have different value in the hand of different acquirers

Buyers/ Sellers leverage Competitive Positioning Distress Sale Vs. Desperate Buy

Strategic Premium/ Discounts: Strategic Premium / Discount arises on account of Operational synergy- Incremental Revenues/ cash Flows Financial synergy- reduce the debt costs Loss in value to acquirer in case target is acquired by competition Ability of acquirer to cut costs in the acquired company

Higher the quality of management, lower the scope for cutting costs

Minority Versus Controlling Interests

All things being equal, a controlling interest is worth more than a minority interest

A holder of a minority interest generally has a passive investment and cannot initiate a sale of assets or require a higher dividend payout

The holder of a controlling interest can influence corporate policy.

Corporate Governance is a key tool to reduce minority interest.

The Three Levels of Value

Control ValueControl Value

Marketable Minority Interest ValueMarketable Minority Interest Value

Non MarketableMinority Interest ValueNon MarketableMinority Interest Value

ControlPremium

Minority InterestDiscount

Marketability Discount

Controlling interests are considered marketable in that they can generally be sold. However, controlling interests are not marketable in the sense of publicly traded minority interests

Indian Regulatory Environment and Minority Interest Safeguard

Snapshot of Indian laws impacting M&A

Laws affecting M&A

Accounting Standards / GAAP

SEBI / SE Listing Requirements

Indirect Tax

Companies Act

Direct Tax

FDI & Exchange Control

Competition ActStamp Duty

Minority interest safeguard- under regulations especially SEBIValuation report from Independent chartered accountant

Audit Committee approval on Scheme and Valuation report

Observation letter from stock exchanges after comments from SEBI

Approval from SEBI after NOC from stock exchanges

Majority votes from public shareholders

Primarily process driven rather than controlling the valuation itself.

May not required by CA firm if no change in shareholding

In addition to approval from board of directors, BoD

Required only under three above instances

Additional shares allotted to promoters*

Scheme involves listed company and any other entity involving promoters*

Listed company has purchased shares of subsidiary intended to be merged with itself, from promoters* in the past

* Includes promoter group, related parties of promoter / promoter group, associates / subsidiaries of promoter / promoter group

Minority interest safeguard- Valuer and company role

Valuer to be independent and resist influence from the companies Extra careful especially when M&A involves related parties (e.g. increase of

stake) Explain key factors to the BoD and audit committee

Methods used/methods not used Significant business plan assumptions Significant valuation assumptions WACC/Discount rate Treatment of surplus assets/contingent liabilities Basis of selection of comparable companies, valuation multiple

Companies Act 2013: Valuation Requirements

Section Particulars

62 (1) c Issue of shares to a non-member

230 Corporate debt restructuring situations

232 Swap ratio for mergers

236 Purchase of minority shareholders

192 Non cash transaction involving Directors

281/305/319/325 Winding up of company situations

Valuation to be done by Registered Valuer. However, Registered Valuer Guidelines are still to be notified

To sum up

Valuation, like beauty, lies in the eyes of the beholder And like beauty, our perception of value changes

Depending upon situations, valuation can be Exactly Wrong

or Roughly correct (if you are lucky)

Questions?

assocham valuation

Documents