A Primer on Valuation

Transcription

1 A Primer on Valuation Introduction Ambitious companies which have plenty of cash look at acquisitions as a way to accelerate growth. What makes a deal attractive to the acquiring company? We do not need to be finance whiz kids to figure out that an acquisition is attractive when the price we pay is substantially less than the value of the additional cash flows we can generate. In turn, that is possible only when the deal valuation is right. Research reveals that in 2 out of 3 cases involving acquisitions of listed companies, the wealth of the acquiring company s shareholders gets eroded. The erosion of shareholder wealth may sometimes be due to integration challenges but in other cases, it is often due to the high price paid by the acquirer for the target company. Despite having astute CFOs and smart advisors ( Read investment bankers), why do companies get the valuation wrong? A short answer is that valuation is as much art as science. Valuation involves various interpretations, assumptions and judgment calls that may sometimes turn out to be wrong. It is not possible to arrive at the exact value but adequate precautions can be taken to ensure that the risks are minimized and the valuation is not too far off the mark. Business leaders need to have a basic understanding of valuation so that they can partner effectively with M&A group, Finance and other functions such as Legal in a due diligence exercise. What follows is a simplified Finance for Non-Finance treatment of the subject. Broad approaches to valuation When the shares of the company being acquired are listed and widely traded, the share price (plus a premium paid to acquire control) is often the basis for the

2 pricing negotiations. But when the company is not listed or if only a division of the listed company is being acquired, we have to use other methods. Very broadly speaking, there are two valuation approaches: a) Discounted cash flows ( DCF) b) Comparative (Relative) valuation or Multiples Other valuation methods are less commonly used. Book value is based on historical costs and backward looking. Liquidation value is too conservative and violates the Going concern principle. Replacement value is more forward looking but it is often not clear what assets will be replaced and how they will be replaced. Option adjusted valuation techniques are too sophisticated, involving complex Black Scholes type of models and parameters such as volatility that are difficult to estimate. The DCF approach In the DCF approach, the incremental cash flows due to the acquisition are estimated over time, typically 5-10 years. Based on the riskiness, these cash flows are discounted suitably to arrive at the present value. (Higher the risk, higher the discount rate.) This value becomes the anchor for the deal negotiations. A small example will illustrate this method. Asssume the target company has 500 employees generating annual revenue of $ 25 million. Say the risk profile of the projects undertaken by the target company is similar to that of the acquiring company. Suppose revenues (and profits) will grow annually at about 20% after the acquisition because of the superior marketing capabilities of the acquiring company. Assume net profit margin is 15 %, the cost of capital is 12% and non cash expenses such as depreciation and

3 amortisation can be ignored. If we take a 5 year horizon, the value of the company can be estimated as : 3.75/ /[1.12]^ /[1.12]^ /[1.12]^4+ 7.8/[1.12]^5 = $ ( )= $19.4 million Comparative Valuation In the Comparative valuation approach, we do not try to estimate cash flows. Instead, we examine how companies similar to the one being acquired, are priced in the market. This figure, with suitable adjustments, becomes the basis for the negotiations. In this approach, we use multiples such as Price to Earnings (P/E), Enterprise value (EV) to Book Value (EV/BV), EV to Sales (EV/S), EV to Earnings before Interest and Tax (EV/EBIT)and EV to Earnings before interest, depreciation, tax and amortisation (EV/EBIDTA). To take an example, if the comparable P/EBIT is 4 and the EBIT of the company being acquired is $ 5 million, then the valuation will be $ 20 million. Choosing the multiple How do we choose the multiple? There is no hard and fast rule but some examples will illustrate the factors influencing the choice. P/E is typically used for stable companies in mature industries where the leverage (Debt to Equity ratio) across the comparable companies is similar. For loss making companies ( ie no gross profit), where sales is the key driver, EV/Sales may make sense. For companies which make a gross profit but an operating loss, EV/EBIDTA may be used. EV/EBIDTA also makes sense when leverage varies across the comparable companies.

4 For companies which make an operating profit but a net loss, EV/EBIT may be used. EV/EBIT also makes sense when leverage varies across the comparable companies. Industry specific multiples are also used : In the Energy and Utilities business, EV/Unit Reserve of Oil or gas is used. In Cements, it could be EV/Tonne of capacity. In Media and telecom, it may be EV/Subscriber. For hotels, EV/Room and in case of banks, Equity value/shareholders equity is sometimes used. For small unlisted IT/BPO companies, we may use price per seat or price per employee. To illustrate the point, if the valuation per employee is $ 38,000, the valuation for a 500 employee acquisition target will be $19 million. DCF vs Comparative valuation The DCF approach is conceptually more elegant. The basic tenet of the DCF approach is that it is better to work with projected cash flows as markets might err in valuing stocks and these errors can persist across sectors and over long periods of time. To take an example, at the peak of the global financial crisis, the mid-tier Indian IT Services companies traded at P/E multiples of 2 4 times of forward earnings. However, during , these stocks were trading in a P/E band of 8 11 times of forward earnings. Clearly there was systematic undervaluation in And this is where DCF scores over Comparative valuation. However, the DCF method is difficult to use due to the challenges involved in estimating future cash flows and their riskiness. In contrast, the comparative valuation approach assumes that markets may value individual stocks wrongly but not the sector as a whole. This approach looks less complicated compared to DCF but needs to be carefully applied. Finding an

5 exactly comparable company is not easy. So in many cases, suitable adjustments have to be made to the multiple. After arriving at the enterprise value, a premium typically has to be paid to gain control of the company. The excess amount paid over the fair value to close the deal is shown on the balance sheet as Goodwill. Unlike Fixed assets or IP, goodwill is not written off over time. It remains on the balance sheet till it becomes impaired, ie the value of the goodwill erodes significantly. Pl do contact me if you want any reading recommendations.