Valuation Of

Business

1
FOREWORD
How does one value a Business?
Why does some one pay a higher amount for
a particular business.
A business worth a significant amount at a
certain point in time may suddenly lose much
of its value in a very short while.
eg. ‘Dot-com companies

2
Value…………
 “Value like beauty lies in the eyes of the
beholder”

 “Price is what you pay, Value is what you get”

Warren Buffet

3
Why Value

To
 Buy
 Sell
 Transact
 Take decisions

4
VALUATION PROCESS

 Review and selection of the methods of

valuation
 Understanding of issues which impact
valuation
 Special situations and their impact on
valuation

5
Value to user

 Valued because of expected return on

investment over some period of time; i.e.
valued because of the future expectation

 Return may be in cash or in kind

6
Complex nature of valuation

Value A + Value B can be

greater
or
less than

Value (A+B)
7
Basic Principles in Business
Valuation

Value of a Business
Risk Involved
Expected Level
Expected Growth in
of
of such Benefits Receiving the Benefits
Economic Benefits
(discount rate)
Value is Based on Prospects

Examine the company’s

Past Performance
operational,
as
investment, and
Surrogate for Future
financial decision making

Prospects
Value Metrics
Value is a function of facts
known and forecast made

The manner in which

the business has operated is often
considered a proxy of the future

Reading the company’s

financial statements

Accuracy,
sustainability, and Composition of Capacity for
predictability of returns on equity continued investment
reported financial results
Steps in Valuation
 Two Way Process
 Data Collection
 Data Analysis
 Estimations & Validations
 Value using various Methods
 Applying Premiums/Discounts
 Applying sanity checks

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Computing value

 Cost vs. Market Value

 Historical vs. Replacement

 Differs depending on need of person doing

valuation – buyer, seller, employee, banker

12
Valuation: What does
it depend on

13
Valuation depends on ….
 Management team
 Historical performance
 Future projections
 Project, product, USP
 Country/ Industry scenario
 Market, opportunity, growth expected,
barriers to competition

14
Valuation depends on…
 Nature of transaction
 Amount of money required
 Stage of company - early stage, mezzanine
stage (pre-IPO), later stage (IPO)
 Strategic requirements and need for
transaction
 Flavour of the season

15
VALUATION METHODS

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Valuation methods

 Different experts have different

classifications of the various methods of
valuation
 Within these methods, there are sub-
methods
 Sometimes the methods overlap

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Valuation methods

These can be broadly classified into:

 Cost ( Asset) based

 Income based
 Market based (Relative)

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COST BASED METHODS

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Cost based methods

 Book value
 Historical Cost
 Current Cost
 Replacement value
 Liquidiation Value

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Book value method

Historical cost valuation

 All assets are taken at historical book value
 Value of goodwill to be added to arrive at the
valuation

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Book value method

Current cost valuation

 All assets are taken at current value and
summed to arrive at value
 This includes tangible assets, intangible
assets, investments, stock, receivables

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Book value method

Current cost valuation: Difficulties

 Technology valuation – whether off or on
balance sheet
 Tangible assets – valuation of fixed assets in
use may not be a straightforward or easy
exercise
 Could be subject to measurement error

23
Book value method
Current cost valuation: More difficulties
 The company is not a simple sum of stand alone
elements in the balance sheet
 Organisation capital is difficult to capture in a
number – this includes
 Employees
 Customer relationships
 Industry standing and network capital
 Etc…

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Replacement value method

 Cost of replacing existing business is taken

as the value of the business

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Liquidation value method

 Value if company is not a going concern

 Based on net assets or piecemeal value of
net assets

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Valuation of goodwill

 Based on capital employed and expected

profits vs. actual profits
 Based on number of years of super profits
expected
 May be discounted at suitable rate

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Valuation of goodwill

 Normal capitalisation method

 Normal capital required to get actual return less actual
capital employed
 Super profit method
 Excess of actual profit over normal profit multiplied by
number of years super profits are expected to continue
 Annuity method
 Discounted super profit at a suitable rate

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Valuation of goodwill

COMPANY A
 Capital employed: Rs. 45 cr
 Normal rate of return: 12 %
 Future maintainable profit: Rs. 5.5 cr
 What would be the goodwill under the normal
capitalization method?
SOLUTION:
 = (5.5/0.12) – 45 = Rs. 0.83 cr

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Valuation of goodwill
COMPANY B
 Capital employed: Rs. 50 cr
 Normal rate of return: 15 %
 Future maintainable profit: Rs. 8 cr
 Super profit can be maintained for:3 years

 What would be the goodwill under the super profit

method?
SOLUTION:
= [8 – (50*0.15) ] * 3 = Rs.1.50 cr
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Valuation of Intangible Assets (IA)
The value of the IA is from
 Economic benefit provided
 Specific to business or usage
 Has different aspects
 Accounting value
 Economic value
 Technical value

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Valuation of IA
Depends on objective and can vary widely
depending on purpose
 For accounting purposes – to show in
financial statements
 For acquisition/merger/investment
 For management to understand value of
company for decision making

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IA value in transactions

Often value paid in M&A deals is more

than market value/book value. This could
be:
 Partly due to over bidding due to strategic
reason (existing or perceived) and
 Partly due to IA of company, not captured
in balance sheet

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INCOME BASED METHODS

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Income Based methods

 Earnings capitalisation method or profit

earning capacity value (PECV)method

 Discounted cash flow method (DCF)

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Earnings capitalisation method
 This method is also known as the Profit earnings
capacity value (PECV)
 Company’s value is determined by capitalising its
earnings at a rate considered suitable
 Assumption is that the future earnings potential
of the company is the underlying value driver of
the business
 Suitable for fairly established business having
predictable revenue and cost models
 Problems: Arriving at Capitalisation Factor

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DCF – Valuation
A Brief View

Valuing a Company

Projecting its Estimating a value

earnings on what happens
for a specific period after the period
(Say 5 -10 years) (Terminal Value)
DCF – Steps
 Forecast of revenue & receivables
 Validating Assumptions
 Consider Product/Industry Life Cycle
 Industry specific factors
 Cost Of Sales & Inventory
 Debt & Equity Mix
 Terminal year

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DCF methods: Starting data
 Free Cash Flow (FCF) of the firm
 Cost of debt of firm
 Cost of equity of firm
 Target debt ratio (debt to total value) of the
firm.

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Template for Free Cash Flow
Working capital

Year 0 1 2
Revenue
“Income Statement”

Costs
Depreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flow
Change in working capital
Capital Expenditure Capital items
Salvage of assets
Free cash flow

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Template for Free Cash Flow

Taxable income = Revenue - Costs - Depreciation + Profit from asset sales

NOPAT = Taxable income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
Add the noncash items you subtracted earlier and subtract the noncash items you added earlier.

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Estimating Horizon
 For a finite stream, it is usually either the life of the product or the life
of the equipment used to manufacture it.
 Since a company is assumed to have infinite life:
 Estimate FCF on a yearly basis for about 5  10 years.
 After that, calculate a “Terminal Value”, which is the ongoing value of the
firm.
 Terminal value is calculated one of two ways:
 Estimate a long-term growth and use the constant growth perpetuity
model.
 Use a Enterprise value to EBIT multiple, or some such multiple

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Weighted Average Cost of
Capital (WACC)

WACC

Return to Return to
Equity Investors Debt Investors
WACC =

 Cost of Equity x percentage of Capital in Equity

 + Cost of Debt x percentage of Capital in Debt

E D
i.e. re ---------- + rd (1-t) ---------------
E+D E+D

where E = the total market value of the company’s equity

D = the total market value of the company’s debt
re = the cost of equity
rd = the cost of debt
t = the company’s effective tax rate

and re > r d
Calculating Terminal value
T = FVn (1+g)
r-g
 T = Terminal value
 FVn = Forecasted Return in year n( final year of
forecast)
 g = Long term sustainable growth rate variable
 R = discount rate

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Arriving at Discount rate

 Using Capital Asset Pricing Model

 E(ri) = Rf + b [E(Rm)-Rf]
 Rf = Risk Free Rate
 b = Beta
 [E(Rm)-Rf] = Risk Premium

 Estimating Beta
 Ks – required rate of return on the security
 Krf = Risk free rate (rate of return on risk free
investment. E.g. GOVT.securities
 β = beta
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 Km – expected return on the over all stock market
Principal difficulties with the
DCF technique
 Long-term cash flow projections are subject
to errors.
 The choice of the discounting horizon, is also
uncertain.
 The terminal value accounts for 60- 70% of
the final valuation
 The projections are as good as the
assumptions
Limitations

 Companies in difficulty
 Negative earnings
 May expect to lose money for some time in
future
 Possibility of bankruptcy
 May have to consider cash flows after they
turn negative or use alternate means

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Limitations

 Companies with cyclic business

 May move with economy & rise during boom & fall
in recession
 Cash flow may get smoothed over time
 Analyst has to carefully study company with a
view on the general economic trends. The bias of
the analyst regarding the economic scenario may
find its way into the valuation model

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Limitations

 Unutilised assets of business

 Cash flow reflects assets utilised by company
 Unutilised and underutilised assets may not get
reflected in the valuation model
 This may be overcome by adding value of
unutilised assets to cash flow. The value again
may be on assumption of asset utilisation or
market value or a combination of these

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Limitations

 Companies with patents or product options

 Unutilised product options may not produce
cash flow in near future, but may be valuable
 This may be overcome by adding value of
unutilised product using option pricing model
or estimating possible cash flow or some
similar method

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Limitations

 Companies in process of restructuring

 May be selling or acquiring assets
 May be restructuring capital or changing
ownership structure
 Difficult to understand impact on cash flow

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Limitations

 Companies in process of restructuring

 Firm will be more risky, how can this be
captured?
 Historical data will not be of much help
 Analysis should carefully try to consider impact
of such change

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Limitations

 Companies in process of M&A

 Estimation of synergy benefit in terms of cash
flow may be difficult
 Additional capex may be calculated based on
inadequate information or limited data
 Difficult to capture effect of change in
management directly in cash flow
 Analyst should try to study impact of M&A with
due care

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Limitations

 Companies in process of M&A

Historically, many M&As have not done as well
as expected. Many times this has been
attributed to valuation being too high. To
minimise this risk of over valuation, a proper
due diligence review (DDR) exercise is to be
done, with one of the mandates for this being
careful review of the value drivers and the
business proposition.

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Limitations

 Unlisted companies
 Difficult to estimate risk
 Historical information may not be indicative of
future, particularly in early stage, growth
phases
 Market information on similar companies can
be difficult to obtain

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 MARKET BASED METHODS
(Relative Valuation)

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Market based Methods

 Sales Multiple
 EBIT Multiple
 P/E multiple
 Price to Book multiple
 Enterprise value to EBIDT multiple

58
Valuation: P/E multiple
 If valuation is being done for an IPO or a takeover,
 Value of firm = Average Transaction P/E multiple  EPS of firm
 Average Transaction multiple is the average multiple of recent
transactions (IPO or takeover as the case may be)
 If valuation is being done to estimate firm value
 Value of firm = Average P/E multiple in industry  EPS of firm
 This method can be used when
 firms in the industry are profitable (have positive earnings)
 firms in the industry have similar growth (more likely for “mature”
industries)
 firms in the industry have similar capital structure

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 Valuation: Price to book
multiple
 The application of this method is similar to that
of the P/E multiple method.
 Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each
rupee of equity invested.
 This method can be used for
 companies in the manufacturing sector which have
significant capital requirements.

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Valuation: Enterprise Value to
EBITDA multiple
 This multiple measures the Enterprise Value (EV), that
is the value of the business operations (as opposed to
the value of the equity).
 EV = MV(EQ)+ MV(Debt)+ MV(Pref Eq)- (Cash+
Investments)
 In calculating enterprise value, only the operational value
of the business is included.
 Generally Value from investment activities, such as
investment in treasury bills or bonds, or investment in
stocks of other companies, is excluded.

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Sample Valuation based on
market methods

A B C
Enterprise market value/sales 1.4 1.1 1.1
Enterprise market value/EBITDA 17.0 15.0 19.0
Enterprise market value/free cash flows 20 26 26

Application to XYZ Co.

Sales Rs. 200 crores
EBIDTA Rs. 14 crores
Free cash flow Rs. 10 crores

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Value estimated

A B C Average
Enterprise market value/sales 1.4 1.1 1.1 1.2
Enterprise market value/EBITDA 17.0 15.0 19.0 17.0
Enterprise market value/free cash flows 20.0 26.0 26.0 24.0

Application to XYZ Co. Average Value

Sales Rs. 200 crores 1.2 Rs. 240 crores
EBIDTA Rs. 14 crores 17.0 Rs. 238 crores
Free cash flow Rs. 10 crores 24.0 Rs. 240 crores

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Exercise in Valuation

D E F
Enterprise market value/sales 2.6 1.9 0.9
Enterprise market value/EBITDA 10.0 21.0 4.0
Enterprise market value/free cash flows 21.0 30.0 24.0

Application to PQR Co.

Sales Rs. 300 crores
EBIDTA Rs. 15 crores
Free cash flow Rs. 7.5 crores

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 Value estimated ?
D E F Average
Enterprise market value/sales 2.6 1.9 0.9 1.8
Enterprise market value/EBITDA 10.0 21.0 4.0 11.7
Enterprise market value/free cash flows 21.0 30.0 24.0 25.0

Application to PQR Co. Average Value

Sales Rs. 300 crores 1.8 Rs. 540 crores
EBIDTA Rs. 15 crores 11.7 Rs. 175.5 crores
Free cash flow Rs. 7.5 crores 25.0 Rs. 187.5 crores

Can this be used as a dependable guide

for valuation 65
Companies in distress- Valuation
 Analyse based on future expected transaction
in which cash flow is identifiable
 Liquidation value
 Sum of parts based on individual
identification of units
 Consider all assets tangible and intangible

66
Relative Valuation
 Using fundamentals
 Valuation related to fundamentals of business
being valued

 Using comparables
 Valuation is estimated by comparing business
with a comparable fit

67
Relative Valuation
 Using fundamentals for multiples to be
estimated for valuation
 Relates multiples to fundamentals of business
being valued, eg earnings, profits
 Similar to cash flow model, same information is
required
 Shows relationships between multiples and
firm characteristics

68
Relative Valuation

 Using Comparables for estimation of firm

value
 Review of comparable firms to estimate value
 Definition of comparable can be difficult
 May range from simple to complex analysis

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Applicability
 Simple and easy to use
 Useful when data of comparable firms and
assets are available

70
Limitation
 Easy to misuse
 Selection of comparable can be subjective
 Errors in comparable firms get factored
into valuation model

71
CCI Guidelines
 These are used when shares are issued to
Non residents by unlisted companies
 Compute Value using
 NAV
 PECV
 Fair Value is average of both above
 As per latest amendment in 2010, Free cash
flow discounting method can be used
Value of equity
 Value of equity
= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities

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 Valuation
Measurements in
Various Industries
Industry Best measure of value

Auto Price to Earnings (PE) multiple

Banking PE and Price to Book Value (PBV) or

Adjusted PBV multiple

Cement PE, Enterprise Value to Earnings

before interest, tax, depreciation &
amortisation (EV/EBITDA), EV/tonne

Engineering Forward PE, which reflects the order

book position of the company
Industry Best measure of value
FMCG PE, Return on Equity (RoE) and Return
on Capital Employed (RoCE) ratios

Real Estate Net asset value (NAV), which is book

value at market prices. Also look at debt
levels

Telecom PE and DCF, because there is a future

stream of cash flows for upfront heavy
investment

Oil & Gas Residual reserves of energy assets

Technology Trailing PE and its growth
What Affects Value in
Industries
Industry Factors Impacting
Auto Volume growth, realisations, operating
profit margins, new product launches

Banking Loan growth, non-performing assets,

net interest margins, CASA ratio
Cement Dispatches, operating costs, regional
demand supply equation

Engineering Order book inflows, execution skills,

margins

FMCG RoE, RoCE, margins, volume growth,

new products, market share
Industry Factors Impacting
Real Estate Debt levels, liquid assets, inventory
levels, promoters’ ability to raise funds

Utilities & Project costs, plant load factors, raw

Power material costs, debt equity ratios

Telecom OPEX , ARPU, TOWERS, debt equity

ratios

Oil & Gas Project costs, debtequity ratios

Technology Order inflow, ability to contain costs,

service verticals, profitability, client
attrition
Finally
 Valuing a business is not completely a science
nor completely an art.
 While there are many known and time tested
method of valuing businesses, at the end of the
day there are a lot of subjective elements that
play a huge part in the valuation process.
 Which method to be used ……..
 Finally it all comes down to what the buyer is
willing to pay.

80
Good Quotes on Investing ……

“The four most expensive words in the

English language are, 'This time it's
different."
Sir John Templeton
"The stock market is filled with individuals
who know the price of everything, but the
value of nothing."
Philip Fisher
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One for the road……
 “Valuation is both an art and a science, but
too much of either is a dangerous thing. A
person infatuated with measurement, who
has his head stuck in the sands of the
balance sheets, is not likely to succeed. If
you could tell the future from a balance
sheet,
then mathematicians and accountants
would be the richest people in the
world by now."
-Peter Lynch