Valuation of Shares /Business Pune West Study Circle - CA Sujal Shah November 14, 2010 Valuation Concept Value – Price Valuation not an exact Science, More of Art and Subjective assessment Value varies with situations Date specific Purchase / Sale of Business Merger/ Demerger Private Equity Buyback of Shares Test of Impairment/ IFRS IPO/ FPO Why Valuation? Litigation Family Separation PPA Regulatory Approval Portfolio Value of Investments Steps in Valuation Obtaining information Management Discussion and Industry Overview Data analysis and review Selection of method Applying Method Conducting sensitivities on assumptions Assigning Weights Recommendation Reporting Sources of Information Historical data such as audited results of the company Future projections Stock market quotations Discussions with the management of the company Representation by the management Data on comparable companies Market surveys, news paper reports Analysis of Company SWOT Analysis Profitability Analysis- Past and vis-à-vis industry Ratio Analysis P&L Ratios Expense & Profitability ratios Balance Sheet Ratios Quick Ratio/ Current Ratio Turnover Ratios Liquidity Ratios Debt Equity- of Company & Industry Principal Methods of Valuation Earning based approach • Discounted Cash Flow • Earnings Multiple Method Market Approach • Market Price • Market Comparables Asset Based Approach • Net Assets Method • Replacement Value/Realisable Value Common Adjustments Following adjustments may be called for: Investments Surplus Assets Auditors Qualification Preference Shares ESOPs / Warrants Contingent Liabilities/Assets Tax concessions Findings of Due Diligence Reviews FDI In India - Revised Pricing Guidelines As per RBI circular dated May 4, 20101) Transfer of shares by Resident to Non-resident (i.e. to foreign national, NRI, FII and incorporated non-resident entity other than erstwhile OCB) In case of listed companies- the price shall not be less than the price at which a preferential allotment of shares can be made under the SEBI Guidelines In case of unlisted companies - the price shall not be less than the fair value to be determined by a SEBI registered Category – I - Merchant Banker or a Chartered Accountant as per the discounted free cash flow method. 2) Transfer of shares by Non-resident (i.e. by incorporated non-resident entity, erstwhile OCB, foreign national, NRI and FII) to Resident The price shall not be more than the minimum price at which the transfer of shares can be made from a resident to a non-resident as given above. Discounted Cash Flow (DCF) Considers Cash Flow and Not Profits Cash is King Free Cash Flow (‘FCF’) FCF to Firm FCF to Equity DCF – Parameters Cash Flows Projections Horizon period Growth rate Discounting Cost of Equity Cost of Debt Weighted Average Cost of Capital (‘WACC’) Cash Flows Business Plan Business Cycle Capital Expenditure Working Capital Depreciation Amortization Tax DCF - Projections Factors to be considered for reviewing projections: Industry/Company Analysis Dependence on single customer/ supplier Installed capacity Existing policy/ legal framework Capital expenditure – increasing capacities Working capital requirements Alternate scenarios / sensitivities DCF – Discounting Weighted Average Cost of Capital (WACC) WACC = D (D + E) x Kd D = Debt E = Equity Kd = Post tax cost of debt Ke = Cost of equity + E x Ke (D + E) DCF - Terminal value Terminal Value is the residual value of business at the end of projection period used in discounted cash flow method. Terminal Value Liquidation Approach Multiple Approach Stable Growth Approach 15 DCF – An Example Particulars Operating PBT Add: Inflows Interest Depreciation Total Inflows Less: Outflows Capital Expenditure Incremental Working Capital Tax Total Outflows Free Cash Flows (FCF) Free Cash Flow for 2014-15 Growth Rate Capitalised Value for Perpetuity Discounting Factor 14.00% Net Present Value of Cash Flows Enterprise Value Less: Loan Funds Less: Contingent Liabilities Less: Preference Share Capital Add: Surplus Funds Add: Value of Investments Adjusted Value for Equity Shareholders No. of Equity Shares Value per share (FV Rs. 10) (Rs. In Mn) 2010-11 2011-12 2012-13 2013-14 2014-15 Perpetuity 170 187 205 226 248 69 81 320 70 85 342 72 90 367 73 94 393 75 99 422 25 39 56 120 200 25 49 62 136 206 25 61 68 154 212 25 54 75 154 239 25 62 83 169 252 0.88 175 0.77 159 0.67 143 0.59 141 0.52 131 252 2% 2,145 0.52 1,114 1,864 (350) (50) (800) 120 1,000 1,784 79,69,000 224 Earnings Multiple Method Commonly used Multiples Price to Earnings Multiple: •Market Cap/PAT Enterprise Value to EBITDA Multiple: •Enterprise Value/EBITDA Sales Multiple: •Enterprise Value/Sales Price Earnings Capitalization Method (PECV) - Parameters Future Maintainable Profits Appropriate Tax Rate Capitalisation Rate/Multiple PECV Based on past performance and /or projections Non-recurring & extraordinary items excluded Profits of various years are averaged (simple or weighted). Current profit is accorded the highest weight Projected profits discounted for inflation By applying effective tax rate, maintainable profit Finally appropriate multiple is applied to arrive at the value arrive at Multiples Multiples to be applied represent growth prospects/ expectations of Company the the Factors to be considered while deciding the multiple: Past and Expected Growth of the Earnings Performance vis-à-vis Peers Size & Market Share Historical Multiples enjoyed on the Stock Exchange by the Company and its peers PECV – An Example Calculation of Adjusted Profit Before Taxes (PBT) Particulars Reported PBT (Rs. in Mn.) 2007-08 2008-09 2009-10 98 116 136 Less: Non recurring / Non operating Income Profit on sale of investments Dividend Income Profit on sale of fixed assets Interest Income Other income Total of Non Recurring Income Add: Non recurring Expenditure VRS written off Preliminary Expenditure Loss on sale of fixed assets Amortisation of Share Issue Expenses One time settlement amount paid to third party Total of Non Recurring Expenditure Adjusted PBT 28 25 4 7 10 74 17 15 18 15 20 9 10 51 7 15 8 15 15 10 10 10 63 9 15 - 32 48 10 58 92 56 113 165 - - PECV – An Example (Contd.) EARNINGS MULTIPLE METHOD- PE MULTIPLE Particulars 2007-08 2008-09 2009-10 Total Maintainable PBT Less: Taxes Maintainable PAT PE Multiple Capitalised Value Adjustments Add: Deferred Tax Asset Less: Preference Share Capital Add: Value of Investments Less: Contingent Liabilities Add: Surplus Funds Equity Value No. of Equity Shares Value per Share (FV Rs. 10 ) Adj. PBT Weight 56 1 113 2 165 3 6 33.22% (Rs. in Mn.) Product 56 225 495 776 129 (43) 86 14 1,210 20 (800) 1,000 (50) 120 1,500 79,69,000 188 Market Price Approach Evaluates the value on the basis of prices quoted on the stock exchange Thinly traded / Dormant Scrip – Low Floating Stock Significant and Unusual fluctuations in the Market Price It is prudent to take weighted average of quoted price for past 6 months Regulatory bodies often consider market value as important basis – Preferential allotment, Buyback, Takeover Code Market Price Method – An Example Month April-10 May-10 June-10 July-10 August-10 September-10 Total Value per Share (in Rs.) Volume 3,47,47,312 1,20,40,227 1,96,63,244 1,61,18,953 1,81,15,567 2,99,08,604 13,05,93,907 Turnover 4,60,92,75,753 1,67,78,68,740 2,47,62,64,011 2,50,32,16,645 3,03,70,62,216 5,53,54,15,743 19,83,91,03,108 152 Market Comparables Generally applied in case of unlisted entities Estimates value by relating an element with underlying element of similar listed companies. Based on market multiples of Comparable Companies Book Value Multiples Industry Specific Multiples Multiples from Recent M&A Transactions . NAV Formula The Value as per Net Asset Method is arrived as follows: Total Assets (excluding Miscellaneous Expenditure and debit balance in Profit & Loss Account) Less: Total Liabilities NET ASSET VALUE OR Share Capital Add: Reserves Less: Miscellaneous Expenditure Less: Debit Balance in Profit & Loss Account NET ASSET VALUE NAV – An Example Particulars Net Fixed Assets Investments Deferred Tax Asset (Net) Current Assets,Loans & Advances Current Liabilities & Provisioins Net Current Assets Loan Funds Net Assets Value Add/ (Less): Adjustments Appreciation in value of Investments Contingent Liabilities Preference Share Capital Adjusted Net Assets No. of Equity Shares (FV - Rs. 10 each) Net Assets Value per Share (Rs. in Mn.) Amount Amount 700 950 20 1,290 (960) 330 (350) 1,650 50 (50) (800) 850 79,69,000 107 Selection of Methods Situation Knowledge based companies Manufacturing Companies Approach Earnings/Market Earnings/ Market/ Asset Brand Driven companies Earnings/Market A Matured company Earnings/Market Investment/Property companies Asset Company going for liquidation Asset Generally Market Approach is used in Combination with other methods or as a cross check Reaching a Recommendation Methods throw a range of values Consider the relevance of each methodology depending upon the purpose and premise of valuation Mathematical weightage Professional judgment Subjective Value Fair Value Method Net Assets Method PECV Method DCF Method Market Price Method Total Fair Value per share (in Rs.) Value per Share (In Rs.) 107 188 224 152 Weight 1 1 1 2 5 (In Rs.) Product (In Rs.) 107 188 224 304 823 165 Other Value Drivers Final Value Final Price is a result of negotiations Documentation Appointment Letter Purpose & Scope of Valuation Valuation Date Commonly used Methodologies Timelines Fees Limitations Representation Letter No material omissions on part of the management Confirmation of all inputs/ information used in the valuation Responsibility for providing information lies with Management Valuation Report Introduction/ Background Purpose of Valuation Key Financials Sources of Information Methodologies of Valuation Important consideration & assumptions Valuation Workings Fair Value Recommendation Exclusions and Limitations Case Laws “Exchange Ratio not disturbed by Courts unless objected and found grossly unfair” Miheer H. Mafatlal Vs. Mafatlal Industries (1996) 87 Com Cases 792 Dinesh v. Lakhani Vs. Parke-Davis (India) Ltd. (2003) 47 SCL 80 (Bom) “Valuation will take into account number of factors such as prospective yield, marketability, the general outlook for the type of business of the company, etc. Mathematical certainty is not demanded, nor indeed is it possible ” Viscount Simon Bd in Gold Coast Selection Trust Ltd. vs. Humphrey reported in 30 TC 209 (House of Lords) Valuation is not an objective exercise. Any preconceptions and biases that an analyst brings to the process will find their way into the value.