Business Valuation Methodology Survey 2017 September 2017 Privileged For limited circulation
Contents Foreword 03 Executive summary 04 Detailed survey results 05 The survey report focuses on business valuation issues and compiles information from specialists intended to provide investors and corporates a reference for valuation analysis.
Foreword Dear Clients and Friends, Welcome to Valueonshore s Business Valuation Survey 2017. We are pleased to publish the results of a web-based survey designed to gather, analyse and share information about emerging trends in the business valuation practices and approaches. Doing business valuations can be challenging given the use of varied methodologies and assumptions. The survey aims at enhancing the uniformity and consistency in assumptions and factors used for valuation purposes under varied situations. We believe the results of the survey would be useful for private equity/venture capital funds, corporates and valuation specialists in their valuation analysis. We would like to thank every respondent for their time and contribution which are invaluable. We look forward to your feedback which will help us to refine future surveys and ensure that we are providing the support you need for performing valuation analysis. With best regards, Gaurav Sahu Managing Director Valueonshore Advisors Business Valuation Survey 2017 3
Executive Summary Valueonshore Advisors has complied the results of the Business Valuation Methodology Survey carried out recently. The survey covered senior executives from Corporates, Private Equity/ Venture Capital funds and Advisory firms. The key highlights of the Business Valuation Methodology Survey relate to: Valuation Analysis The key concerns highlighted by the participants while reviewing reports included demonstrating commercial reasonableness and sensitivity analysis on subjective inputs impacting valuation. Valuation Methods Amongst various methods, the Income Approach and Market Approach seem to be the preferred approaches given these methods factor the future earning potential of an enterprise. Terminal Value Gordon Growth Model is the preferred model to determine Terminal Value. The key factor impacting terminal value is the terminal growth rate which is considered closer to the regional GDP growth rate. Discounting Factor The mid year discounting convention is preferred over the year end discounting factor given that cash flows accrue to an entity throughout the year and not at a particular point in time. Debt Level While performing a valuation analysis, participants preferred to utilise target level of gearing of the company for beta and WACC computation purposes. Beta Given the high volatility in emerging markets, respondents preferred to utilise a longer duration beta implying that cash flows generally take time to stabilise for growth companies being valued. Risk Free Rates Participants preferred to use Treasury bills, represented by the local currency government bond yields, for determining risk free rates. Adjustments to discounting There were divergent views on taking additional discounting factors. We have observed that participants considered additional discounting adjustments such as control premium, marketability discount, small stock premium, etc. for the valuation analysis. Business Valuation Survey 2017 4
Detailed survey results
1. Valuation Reporting Business valuation can be challenging due to technical methods requiring multiple inputs which may not be readily available. A sensitivity analysis helps in analysing subjective inputs impacting valuation. Q: What are the most common issues faced while reviewing valuation reports? Questionable methodologies 19 Subjective inputs not reasoned 35 Lack of commercial reasonableness 35 Simplistic analysis 11 0% 20% 40% The results of the survey indicate that 35% of the respondents find Lack of commercial reasonableness and Subjective inputs not reasoned to be the major concern while reviewing valuation reports. This is perhaps not surprising given transparency and quality of information is not adequate in growth stage companies, due to lower management focus on financial reporting systems. A relatively smaller number of participants faced the challenge of Questionable methodologies and Simplistic analysis. Business Valuation Survey 2017 6
2. Valuation Methodology There are various methodologies that can be utilized by financial analysts and corporate finance professionals when performing a business valuation. In growing economies, it is more difficult to forecast the profitability of privately held companies possibly due to lack of reliable financial information and non- availability of comparable company data. Q: Which is the most preferred Valuation methodology assuming a business is a going concern? Income Approach 72 28 Market Approach 61 39 Asset Based Approach 18 56 26 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Always Sometimes Never Income Approach (Discounted Cash-Flow Approach) and Market Approach are the preferred valuation approaches with an underlying assumption of going concern. In the survey, participants preferred the use of Income Approach and Market Approach since these approaches consider the income generating potential of the business. Lesser number of respondents considered the Asset Based Approach, since this is more suitable in situations where the company is being liquidated as an standalone asset and not as a going concern. Business Valuation Survey 2017 7
3. Income Approach: Discounted Cash Flow The Capital Asset Pricing Model ( CAPM ) is the most widely used risk-return model in determining cost of equity ( Ke ). It measures risk in terms of systematic risk (i.e. Beta or risk inherent to the entire market) and relates expected returns to this risk measure. CAPM only compensates for systematic risk as it assumes that a rational investor will hold a diversified portfolio, resulting in the elimination of unsystematic risk (also referred to as "firm-specific" or "diversifiable risk"). Q. When using the Income Approach, which are the methods used to calculate cost of equity? Capital Asset Pricing Model 60 International Capital Asset Pricing Model 31 Other 9 0 10 20 30 40 50 60 70 Mostly Never Majority of the participants in the survey use the CAPM method which describes the relationship between risk and expected return. Capital Asset Pricing Model and multi factor International CAPM are preferred since these methods are easy to use and provide a meaningful outcome. Business Valuation Survey 2017 8
4. Market Approach As far as Market Approach is concerned, a number of valuation benchmarks can be used in its application. The EV/EBITDA is the preferred approach while deriving the value of a business. It s prominence in business valuation is rooted in how the Market Approach methods are also used as "sanity checks" in valuing enterprises. Q. When using the Market based Approach, which are the preferred multiples you use? Price/Earnings 35 40 25 EV/EBIT 50 30 20 EV/EBITDA 80 20 EV/Revenue 15 55 30 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Always Sometimes Never In the survey, participants favored the use of Enterprise Value / Earnings Before Interest Tax Depreciation and Amortization ( EV/EBITDA ) in their analysis since this approach allows comparison with firms having different capital structures when analysing the cash flow to all providers of capital. Business Valuation Survey 2017 9
5.1 Income Approach: Terminal Value Method For a going concern business, we wanted to understand the dynamics of arriving at the Terminal Value (i.e. value at perpetuity). An estimate of Terminal Value is crucial in the Valuation Analysis as it accounts for a considerable portion of the business value, more so in growth oriented companies. The Terminal Value should normally be determined for steady state cash flows to have a commercially reasonable valuation analysis. Q: When determining the Terminal Value, which methods are considered? Percentage 28 72 Exit Multiple Gordon Growth Model The Gordon Growth Model (also known as the Perpetuity Model) is the most popular methodology used in terminal value calculations. Most of the participants i.e. 72% consider the use of Gordon Growth Model since the model can be used on the future period cash flows that are assumed to grow at a constant rate. Few participants consider the Exit Multiple Model which is easy and quick to use since it factors expected return and is normally based on EV/EBITDA of similar or competitor companies. Business Valuation Survey 2017 10
5.2: Income Approach: Terminal Value Growth Rate Terminal growth rate is a key input required in the Gordon Growth Model. Estimation of terminal growth rate involves a significant amount of judgment, since this is a constant / steady-state growth rate that extends to perpetuity. Typically, steady-state growth rates are assumed to be closer to the country specific GDP growth rate in which the business operates. Given the variability in GDP rates, a sensitivity analysis is performed on the assumption. Q : When using the Gordon Growth Model, how do you usually determine the residual (terminal year) growth rate? Industry Trend 11 Inflation (specific to a country) 22 Long Term bond Yields 22 GDP Growth 45 0% 10% 20% 30% 40% 50% GDP growth rate is a preferred factor considered for long term growth rate given all companies (in different stages of growth) contribute jointly to add value to the economy. Most of the participants use GDP growth for determining residual growth rate. Additionally, a smaller number of participants consider the use of Long term Bond yields, Inflation and Industry Trend. Business Valuation Survey 2017 11
6: Income Approach: Discounting The method of discounting cash flows inherits a problem of assuming that the entire value of cash flow for a given year arrives at the very end of a year. However, commercially, the cash flows in over the year and not at a particular point in time. Accordingly, we asked our respondents on whether they apply Year End discounting or Mid Year Discounting, to understand the industry convention on discounting. Q: When discounting under DCF, which discounting convention is preferred? Year End 33 Mid Year 67 Percentage The mid-year discounting convention is the preferred approach given it is safer to assume that cash flows are generated evenly throughout the period. It can be seen that majority of the participants use the mid year convention since it helps even out the impact of seasonality that certain industries may witness. Business Valuation Survey 2017 12
7. Adjusting for Country Risk Premium The application of Country Risk Premium ( CRP ) in the multi factor model is important since stakeholders assess and quantify the risks inherent in investing in different regions. The CRP is higher for emerging markets. CRP refers to the difference between the higher interest rates (that less stable and riskier countries must pay to attract investors) and the interest rates of an investor's home country. Q: When valuing assets in Emerging Markets, how do you generally adjust for country risk? Premium based on Local Bond Yields and USD Bond Yields 15 Add an appropriate Premium 20 Determing an appropriate risk free rate for a country based on implied premiums using country credit ratings 65 0 10 20 30 40 50 60 70 Percentage When using the International Cost of Equity method, the CAPM is adjusted with Country Risk Premium. Sanity checks on the premium are performed basis the published studies / research data on Country Risk Premium. In the survey, participants prefer to work with Determining an appropriate risk free rate for a country based on implied premiums using country credit ratings and adjusting it to the cost of capital to factor country specific risks. This approach relies on standardized data for country risk adjustments. Business Valuation Survey 2017 13
8. Risk-free rate Risk free rate is the rate of return for an investment with no risk factor. It represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. Q: Which of the following do you use for Risk free rate determination? Local Currency Bond Yield 90 US risk free rate plus a country risk premium 67 Others 10 Percentage The survey findings show that majority of participants considered the use of Local Currency Bond Yield followed by 67% who considered the use of US risk Free rate plus a country risk premium during their valuation analysis. Treasury bills are the most common example of assets that offer a riskfree rate of return. Accordingly, long duration local government bond yield are used as a proxy for risk free rates which is important in the CAPM model. Business Valuation Survey 2017 14
9. Analyzing Premium The CAPM model describes the relationship between systematic risk and expected return. Additionally, each firm depending on their valuation purposes may factor additional adjustments in determining the discounting factor. Q: Which of the following premiums do you consider during a valuation analysis? Small Stock Premium 23 Marketability Discount 50 Control Premium / Minority Discount 90 0 10 20 30 40 50 60 70 80 90 100 Percentage Based on the valuation objectives additional adjustments are factored to make the Valuation Analysis commercially reasonable. Majority of the participants considered the use of Minority Discount or Control Premium depending on the proposed shareholding Participants also considered the use of Marketability Discount where the business is not listed implying the illiquid nature of the stock Business Valuation Survey 2017 15
10.1: Beta Concept and Timeframe Beta measures a company s volatility or systematic risk relative to the market. Capital structure varies from company to company and is one of the factors leading to a change in beta in similar/ comparable companies. Unlevered beta removes the effects of debt of similar / comparable companies. Re-levering the beta takes into account the capital structure relevant for the target company. Q: Do you apply equity betas directly or first unlever and relever the observed equity betas to apply to the subject company? Percentage 15 85 Source Equity beta directly Unlever and then relever observed equity beta Re-levering beta specific to a company is the preferred approach since this takes into effect the capital structure. In the survey, majority of respondents consider to unlever and then relever equity beta while performing a valuation analysis since this factors the debt level of the entity being valued. A minority of respondents considered to Source Equity beta directly which is performed for determining quick estimates with an assumption of industry debt level. Business Valuation Survey 2017 16
10.2: Beta Period to be used Time frame (i.e. period and frequency for estimation) chosen for calculating beta is critical for the purpose of valuation analysis. The equity duration is a measure of a share s cashflow maturity. Stocks that pay a large fraction of cash flows in the distant future should use a long period and lesser frequency beta. Rapidly growing companies may need growth capital expenditure and may have negative cash flows resulting in non payment of dividends in the initial phase. In contrast, stocks with stable cash flow use a short period and higher frequency beta. For instance, utility companies with stable cash flows may not require growth capex and may have stable dividend-price ratios. Q: When calculating the beta, what period do you generally consider appropriate? Percentage 8 34 58 3 Years 1 Years Others In emerging markets, a longer duration beta is preferred since it brings more stability to the valuation analysis. In the survey, when it comes to understanding the time frame for beta, more than half of the survey s participants considered 3 years beta as it captures the longer duration of cash flow maturity for the valuation analysis. Less than half of respondents considered beta of less than 3 years. Business Valuation Survey 2017 17
11 : Applying Cost of debt Greater use of leverage may increase the likelihood of financial distress, which will increase both the cost of debt as well as the cost of equity. Thus, it is important to understand the current and future cost of debt and the interest coverage ratio of the company. Q: How do you determine the cost of debt for valuation purposes? Incremental cost of debt of company being valued 80 Cost of debt for comparable companies 10 Implied cost of debt given credit rating of company being valued 10 0 10 20 30 40 50 60 70 80 90 100 Percentage Cost of debt refers to the effective rate a company pays on its current debt and would pay on anticipated debt levels. A large majority of the respondents preferred to use the Incremental cost of debt of company being valued for determining the cost of debt for valuation purposes. Participants also considered the cost of debt for comparable companies which would mostly be for cases where publicly available data on comparable companies is available. Another method used is the Implied cost of debt given credit rating of company being valued where data on similar rated debt instrument is available for comparison. Business Valuation Survey 2017 18
12: Debt and Equity Evaluating a company s capital structure is a significant aspect while doing a valuation analysis. Using an appropriate level of debt and equity can potentially boost the financial performance of the company. The level of debt to equity in a company and the approach in determining the appropriate level of debt to equity may vary from industry to industry. Q: What are the approaches you use in determining the appropriate level of debt and equity? Acquirer's intended level of gearing for the entity 75 Average gearing level of the industry in which the entity operates 60 Entity's actual debt to equity 30 Theoretical target gearing level of the entity 20 0 10 20 30 40 50 60 70 80 Percentage Most of the participants considered Acquirer s intended level of gearing for the entity as the appropriate method for debt to equity ratio. This is since anticipated debt levels are factored in the future financial projections. Participants also considered the Average gearing level of the industry in which the entity operates and Entity s actual debt to equity ratio. Only a small percentage of respondents considered the use of Theoretical target gearing level of the entity. Business Valuation Survey 2017 19
About Valueonshore Advisors Valueonshore Advisors, founded in 2010, is a specialised professional services firm formed by Big 4 alumni and Industry executives with decades of Accounting and Advisory experience. We are a partner of choice for numerous multinational and Indian clients who engage us for our unique combination of functional expertise and industry knowledge, and for our objective solutions to complex problems. Our client portfolio includes multi-billion dollar companies, mid-cap public and pre-ipo companies that range from late stage to early stage. The respect and reverence that the Firm commands is evident from the fact that it is consistently recognized for the work done for its clients. The firm has approximately 200 professionals with operating offices in India (Gurgaon, Mumbai and Bangalore) and Singapore other than sales offices in the US and UK. Our Valuation Services Group has provided a wide array of valuation services to clients across Industry sectors with varied objectives including for domestic and cross border transactions, financial reporting, regulatory and other strategic purposes. If you need any further information on the survey report or our valuation services, please do get in touch with the contacts below: Gopal Mitruka Director gopal.mitruka@valueonshore.com Our Presence Valueonshore Advisors Delhi NCR 5th Floor, Mawandia Towers, 463, Phase V, Udyog Vihar, Gurgaon - 122 016 Tel : +91-124-4221000 Valueonshore Advisors Singapore 29 Mayo Street, #03-03, Singapore - 208315 Tel : + 65-91386028 Email : info@valueonshore.com www.valueonshore.com Ankit Varma Vice President ankit.varma@valueonshore.com Valueonshore Advisors Mumbai 5th Floor A Wing, Akruti Trade Centre, 7th Road, MIDC, Andheri (East), Mumbai - 400 093 Tel : +91-22-3222 7418 Valueonshore Advisors Bangalore 19A, Srinivasa Nilaya, New Manjunatha Layout, Ramamurthy Nagar, Bangalore 560 016 FOLLOW US Disclaimer The information contained in this publication has been compiled or arrived at from sources believed to be reliable, but no representation or warranty is made to its accuracy, completeness or correctness. The information contained in this document is published for the knowledge of the recipient but is not to be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient. This document is not intended to be a substitute for professional, technical or legal advice or opinion and the contents is not intended to answer specific questions or suggest suitability of action in a particular case. Whilst due care has been taken in the preparation of this report and information contained herein, Valueonshore Advisors does not take ownership of or endorse any findings or personal views expressed herein or accept any liability whatsoever, for any direct or consequential loss howsoever arising from any use of this report or its contents or otherwise arising in connection herewith.