Market vs Intrinsic Value

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2 Market vs Intrinsic Value Market Value Determined by the consensus of market participants Observed in the market Intrinsic value Present value of expected future cash flows Not observed Estimated using valuation methods

3 Investment Decisions If MV = IV; fairly valued (Hold?) If MV < IV; undervalued (Buy?) If MV > IV; overvalued (Sell?)

4 Valuation Methods Valuation Methods Assets Value DCF Relative Valuation Replacement Value Liquidation Value FCF Discount Dividend Discount Multiples

5 Asset Based Valuation Valuation at adjusted net worth Adjusted net worth = adjusted assets adjusted liabilities Adjustments are in respect of market values Not commonly used other than as a cushion for other valuation or in a liquidation or winding up Cash/earnings generating capabilities are ignored

6 Dividend Based Valuation Constant Dividend Growth Model

7 Constant Dividend Growth Model

8 Supernormal Dividend Growth

9 Supernormal Dividend Growth

10 Supernormal Dividend Growth

11 Supernormal Dividend Growth

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13 Valuation Discounted FCF Key Components of DCF valuation Forecasting unlevered Free Cash Flow Discount Rate - WACC Forecasting Terminal Value Computing Enterprise Value (EV) and deriving Equity Value

14 Free Cash Flow FCF is the cash flow available to all the capital providers of a company after all the operating expenses, taxes and capital investments (both WC and fixed) EBIT Taxes = NOPAT NOPAT + NCE CapEx Inc WC = FCF

15 WACC WACC represents the required rate of return to all forms of capital providers Cost of Equity CAPM and Beta K e = R f + ß (R m R f ) ß Levered = ß Unlevered x [1+ D(1-t)/E) Cost of Debt Post tax YTM Cost of Equity > Cost of Debt Don t penalise equity heavy companies with high WACC as low debt reflects ability to leverage in the future

16 Terminal Value Terminal value captures the firm s value for the time beyond the explicit period, which can be theoretically extended into perpetuity Ideally at least 1/4 of DCF value should be captured by the explicit forecast period Popular methods Liquidation/Salvage value (multiple of BV) Exit multiple (multiple of NI/ EBITDA/ EBIT Perpetuity Capitalisation of final FCF (static or growth)

17 Enterprise Value EV = OA + NOA(incl. Cash) OA = PV of FFCF EV = DFCF + NOA(incl. Cash) EV = Market Cap + PS + NCI + Debt Market Cap + PS + NCI + Debt = DFCF + NOA(incl. Cash) Market Cap = DFCF+ NOA PS NCI Net Debt

18 Common DCF Errors Inappropriate forecasts Short forecast horizon Hockey sticks Rapid trend changes Internal inconsistencies (Contradictory assumptions - Expanded output and reduced Cap-Ex) Aggressive or conservative: How many good things have to happen simultaneously Terminal Value manipulation Improper cost of capital Non operating assets Discounting discounted cash flow

19 SOTP Valuation Sum Of The Parts (SOTP) valuation is a methodology used to arrive at the total value of an entity by valuing each segment of the business separately and adding the segment values to arrive at the value of the total entity

20 Case Study

21 Case Observations TSE Observations Margins are under pressure declining margins Revenue growth but with declining margins Cash rich in spite of healthy dividend payments YVC Observations Good operating margin (~20%) Margins maintained with sales growth Margin improvements may be due to operating leverage PPE appears to be very old (low depreciation) Heavy cap-ex during the last few years Except the spike from 1999 to 2000, rest of the growth rates are not aggressive

22 Valuation TSE is going to be a strategic investor, therefore absolute valuation (DCF) is appropriate. Comparable P/E Multiple may be done for a comparison Simple average of P/E multiples If the valuation is for the whole business based on unlevered basis EV/EBIT basis may be used instead of standard P/E multiple Exit price for Terminal Value Exit price of TV may be assessed at 10x EBIT which is quite reasonable for an average growth entity. Even if the acquirer is making a strategic investment (where DCF is preferred) the exit price of TV may be used for negotiation purposes.

23 Valuation of YVC Absolute value of $132Mn net of cash is 9x trailing P/E (1999A) and 6x forward P/E (2000F) Interest income on treasury securities should have been adjusted as non operating income Control premium to be added on P/E value of $57Mn mkt cap 21.98) The value of (457Mn + control premium) is still at a good discount to the absolute value of $132Mn The seller may argue for a higher price on the basis of excellent growth prospects in the future Compare valuations using P/E and other multiples given on page 15 of the case

24 Liquidation and Replacement cost valuation Matters for attention US Treasury investments can be assumed to have been M2M Due from US Govt. may have to be discounted due to delay in receipt (consider materiality) Accounts receivable consider if further discounting is required (DD matter) Inventories usability and relevance, any further provisions? (DD matter) Deferred assets may have to be even zeroed Comments The current market value appears to be just at the liquidation value. Thus it appears to be under valued Replacement cost appears higher than equity value based on current market values (based on market multiples) Therefore it is a good potential candidate for a LBO/MBO

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26 Relative Valuation Relative Valuation utilises market prices from observed transactions to impute the value of a target investment opportunity Process Identification of appropriate comparable firms Identification of the relevant valuation metric(s) Computation of valuation metric multiples for the comparable firm(s) Apply to the target firm (with adjustments for specific attributes)

27 Multiples Multiples are driven by Risk Growth Cash generating potential / Profitability Popular Multiples P/E; P/EBIDTA P/BV P/Sales P/Cash Flow EV/EBITDA

28 Identification of Comparable Firms - Dimensions of Comparability Business Product / Service Offerings Delivery / Distribution Mode Size Investability Liquidity Geography Profitability Growth prospects Capital Structure Financing growth availability of internally generated funds

29 Identification of Valuation Metric Balance Sheet Metrics Book Value (Net worth) Net Asset Value Income Statement Metrics Net Income (EPS) Yield Dividend Discount Model (DDM) The Economic Metrics Revenues EBITDA / EBIT

30 Identification of Valuation Metric - Hot Button Profile Mature Net Income (EPS), BV Capital Intensive EBIT, EBITDA, CEPS, FFO Thin Margins - EBIT, EBITDA, CEPS, FFO High Leverage - EBIT, EBITDA, CEPS, FFO Slow Growth - EBIT, EBITDA, CEPS, FFO Financially distressed Revenues, BV, NAV Emerging Revenues, EBITDA

31 Identification of Valuation Metric - Some sector specific examples Financial Services, Constructions Book Value Utilities EBIT Energy, Automobile, Mature Technology Net Income (EPS) Grocers, Telecoms, Media EBITDA, CEPS, FFO Real Estate NAV, FFO Multiple Sectors / Diversified Net Income

32 Identification of Valuation Metric - Some operational metrics EV / Unit of resource Natural resources, Metals EV / Unit of capacity Logistics, Manufacturing, Real Estate, Retail EV / Customer Utilities, Technologies, Cable TV, Telecoms, Financial Services

33 Case Study

34 Screening and initial analysis Quaker Oats Just after a very bad acquisition and disposal New management team Pepsi Co Under pressure to push P/E up (31x vs 41x in Coca-Cola) Many low margin business segments Target EPS growth 12%-13% (ref. p3 of the case) need a growth vehicle

35 Case observations Pepsi Co (Addition by subtraction ref. Table 1) Downsizing in terms of revenue and assets low margin low return segments have been dropped Increase in ROIC and margins Higher multiples are attached to quality assets generating higher cash flows From Pepsi Co., POV this dog (OATS) could be turned around to a cash cow and may even be spun off later to a private equity Boot strapping an entity with high multiples could achieve accretion of value by acquiring low multiple stock

36 Questions to be answered Fairness of the deal to the target: Is the price fair and a suitable premium awarded Is the % control premium comparable to premiums in past comparable transactions? (Historic control premiums in public companies are 20%-40%) Do the acquisition multiples represent a premium to public company comparable multiples? Are the acquisition multiples comparable to multiples in past comparable multiples? Attractiveness of the deal to acquiring shareholders (Accretion vs dilution) Is the acquisition accretive or dilutive and over what time horizon?

37 Fairness of the Deal to the Target Is the control premium comparable? 2.3 PEP shares for each share of Oats 26% premium on Nov 2 nd price Even higher premium on pre announcement price which is >40% There is a fair control premium

38 Fairness of the Deal to the Target Acquisition Multiples EV / EBITDA = EV / Revenue P/E = = EBITDA / Revenue = 18.4% Compare the above multiples with the highest of values among the 6 comparable companies given in the case Compare the above multiples with those of Kellogg which appears to be the most comparable of the 6 comparable companies given in the case as far as the business segment is concerned However in terms of profitability and capital structure Hershey may be a better comparable

39 Comparability to comparable transactions (Ref. p.6 of the case) EBITDA Multiples Phillip Morris / Nabisco 14.0x Unilever / Best Foods 13.5x Kellogg / Keebler 10.3x Average 12.0x PEP / Oats transaction is at 15.38x which is at a premium of 26% Average net income multiple is 27.5x and PEP/Oats transaction is also at similar multiples Based on the above analysis the offer appears to be fair for the target Oats.

40 Attractiveness to the acquirer Synergies Revenue synergies to be: > 2 Cost synergies: < 2 PV (Synergies) > Control Premium PV(Synergies) computation should consider any Cap-ex, if material needed to realize the synergies Discount rate for synergies No relationship to COC of PEP or Oats If probability of synergies is high, even the risk free rate could be used If the synergies are very aggressive a rate as high as 20% may be used If the synergies are moderate a rate in between may be used