The Institute of Chartered Accountants of Pakistan Riyadh Chapter IFRS13 and Valuation Techniques Important Notice This document, which has been prepared by Deloitte Transaction Services LLC ( Deloitte ), has been prepared for the sole purpose of outlining our credentials to provide assistance to you in order that you may evaluate the capabilities of Deloitte.
Presenters
Presenters Munish Mohendroo Director Valuation and Business Modelling Services Deloitte Corporate Finance Limited Abu Dhabi Phone: +971 2 408 2424 Email: mmohendroo@deloitte.com Abid Moosa Assistant Director Valuation and Business Modelling Services Deloitte Transaction Services LLC Kingdom of Saudi Arabia Phone: +966 11 288 8613 Mobile: +966 56 858 0250 Email: abmoosa@deloitte.com 2
IFRS 13 Fair value measurement
Value why and when? Transactional Legal/ Regulatory Internal decision making Financial reporting Independent experts Deloitte valuations in Middle East 30 experts Across the GCC Businesses, shares, tangible and intangible assets Practical guidance: IVSC (International Valuation Standards Committee) RICS red book for real estate IFRS - financial reporting purposes 4
Introduction to IFRS 13 Fair Value Measurement Introduction Originally issued in May 2011 Applies to annual periods beginning on/ after 1 January 2013 Single source of guidance for fair value Defines fair value Guidance on determination Consistent disclosures requirements Not when, but how fair Applies to all transactions and balances Exception - transactions accounted for under IFRS 2 Sharebased Payment and IAS 17 Leases. 5
The Previous Definition of Fair Value Fair value definition The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm s length transaction. Its weaknesses It did not specify whether an entity is buying or selling the asset. It was unclear about what settling meant because it did not refer to the creditor. It was unclear about whether it was marketbased. It did not state explicitly when the exchange or settlement takes place. 6
IFRS 13 s new Definition of Fair Value New fair value definition The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Its improvements It specifies that the entity is selling the asset. It refers to the transfer of a liability. It is not a forced or distressed sale. It is clear it is market-based. It states explicitly when the sale or transfer takes place. 7
Valuation Concepts Market pricing NOW - exit price, market pricing, orderly transaction Before exchange, knowledgeable and willing, not as explicitly defined Seller 150m Buyer 100m Willing buyer and seller would usually settle between 100m and 150m 150m starting point but may not be the exit price per IFRS13 Depends on the availability of prices of Comps Issues to consider include: related parties duress or forced sale 8
Valuation Concepts Market participants Market based not entity specific Assumed access to principal market (greatest volume) or most advantageous market (greatest price) Willing Seller & Buyer Market Participants Principal market or Most advantageous market Principal or most advantageous markets likely to be the same as competition would eliminate any differences 9
Highest and Best Use Highest and best use Non-financial assets are to be valued on a highest and best use basis Market participant would maximize the value Physical Legal Financial Current use is often but not always = to highest and best use Intangible and financial assets typically have only one use E.g. Brand name or software cannot be converted into something else without it becoming a different intangible asset 10
Highest and Best Use Determination process All available alternative uses Step 1 Physically possible uses Step 2 Physically possible, legally permissible uses e.g. Potential uses 1, 2 and 3 Step 3 Physically possible, legally permissible financially feasible uses e.g. Potential uses 1 and 3 (2 not financially feasible) Step 4 Highest and best use Highest return from potential uses 1 vs. 3 11
Highest and Best Use - Example Dubai real estate An investment fund acquired a commercial office building on the Palm Jumeirah as an asset included in a wider business combination. Given the hotel, leisure and residential nature of the Palm, it is not a popular choice for commercial office buildings, and occupancy has traditionally remained low. Value of this asset has accordingly been reflective of this. The building has been authorized for conversion to a residential tower after some structural changes which according to engineers can easily be made. In this example, the highest and best use of the commercial office building would be determined by comparing: a) the current value of the building as a commercial office building; and b) the value of the building as a residential tower after conversion and deduction of cost of conversion. The highest and best use of the asset would be determined based on the higher of these values. 12
Challenges Challenges and conclusions Local markets have limited comparability and not as voluminous Markets are largely inefficient and prices may not reflect complete information Availability of timely relevant information is a challenge Considering the principal or most advantageous market in GCC Related party transactions due to closed community (KSA, UAE, Qatar, Kuwait) 13
Conclusion Points Challenges and conclusions Overall, fair valuation not too dissimilar to current practice Detailed disclosure changes expected Technical interpretation may have variations Fair values are likely to be scrutinized more and Auditors likely to seek more substantiation behind assumptions and conclusions Third party or expert inputs may need to be sought more 14
Valuation Fundamentals
Value Definition Fair Value Vs. Fair Market Value Price in cash equivalent Hypothetical willing and able buyer and seller Acting at arm s length Open and unrestricted market Neither under a compulsion to buy or sell Both have reasonable knowledge Value Principles Specific point in time (hindsight excluded) Function of prospective earnings/ cash flow Market dictates rates of return Underlying net tangible assets may influence value Commercial and non-commercial value 16
Value versus Price The value is $5m, we just paid that in January Worth on paper (value) may differ substantially from amount paid (price) Intrinsic value VS. Negotiated Price Why Price and Value May Differ Differing views of the asset Negotiation strengths of the parties Different assessments of synergy potential Non-business motives - e.g. sports franchises and other trophy assets Distressed (bargain purchase) or related party sales 17
Differing Viewpoints on Cash Flow Buyer Seller Past may be future! Reliance on small group of customers Sustainability of customer relationships Reliance on owner Past is no reflection of future! Ready to take-off Profits down due to investment for future We ve just achieved critical mass 35,000 35,000 30,000 30,000 25,000 25,000 20,000 20,000 15,000 15,000 10,000 10,000 5,000 5,000-2006A 2007A 2008A 2009A 2010A 2011F 2012F 2013F - 2006A 2007A 2008A 2009A 2010A 2011F 2012F 2013F 18
Valuation Approaches
Valuation Approaches Going-concern Approach Cost approach Income approach Market approach Entities Liquidation Approach Asset based orderly or forced Valuation Approaches Specialized Assets Same Approach as for Entities Cost approach Income approach Market approach 20
Three Main Approaches to Valuation The Cost Approach Not pay more than what it would cost to replace Direct/ indirect cost method Adjusted Net Assets Method The Market Approach Pay no more than what a comparable property could be purchased for Comparable/Guideline Company Precedent Transactions The Income Approach Present value of future returns Capitalization of Earnings/Cash Flows Discounted Cash Flow Method 21
Valuation techniques Valuation techniques Cost Replacement / Reproduction Key considerations Availability of comprehensive cost data Replication to current depreciated state Functional obsolescence Economic obsolescence Market dilution Inflation Loss of profits during reproduction Logically rationalizing historical cost vs. current cost Cost Cost Approach Approach Income Income Approach Approach Market Market Approach Approach 22
Market Approach Why perform comparable analysis? Value private companies Value segments of larger companies Derive a range of possible values for a TARGET Test market valuation of public companies Frame in other valuation approaches Basic premise is that the equity markets have a view on the risk and return inherent in various industries Why Transactions? deal-speak Industry-specific multiples Insights (Premium, Valuation techniques, Bidding strategies etc.) Cost Cost Approach Approach Income Income Approach Approach Market Market Approach Approach 23
Some Attributes of Different Multiples 24
Market Approach Trading Multiples Example Common Errors Inappropriate selection Use of mean/ median No adjustments Inappropriate adjustments Mismatch of multiples and financial data Relying on third-party data without validating 25
Market Approach Transaction Multiples Example Problems Limited number of transactions Dated information Missing data Lack of relevant What do you mean my company is worth only $350 million? Do you know that Company X, my direct competitor, just sold for $860 million. 26
Income Approach Valuation techniques Income Discounted Cash Flow Method Capitalization of Cash Flow/Earnings Dividend Discount Model Excess earnings Relief from royalty Key considerations Turnover / earnings / free cash flow profiles Discount rates / growth rates Time periods and UEL of assets Royalty rates / Contributory asset charges Tax and tax amortization benefits Cost Income Cost Income Approach Approach Approach Approach Market Market Approach Approach 27
Capitalization Rate and the Multiple Factors determining the discount rates: Size Capital intensiveness Volatility of earnings (i.e., risk) Depth of management The inverse of the capitalization rate = the multiple Example: 20% rate 1/20% = 5x multiple Capitalized cash flow example All amounts in $000s After-tax maintainable cash flow 15,000 Capitalization rate 20% Multiple (inverse of capitalization rate) 5.0 x Capitalized cash flow value 75,000 28
Income Approach - Discounted Cash Flow The Value Formula - DCF Cash flow discounted to PV at the appropriate discount rate = Going concern value of the operations + Non-operating/redundant assets = Fair market value of the business Cash flows for explicit forecast period + Terminal value 29
Free Cash Flow Computation FREE CASH FLOW COMPUTATION EBIT - Cash Taxes + Depreciation & Amortization - Capex - / + Increase/ (decrease) in Net Working Capital = Free Cash Flow (Entity or levered) Common Errors Optimistic forecasts Capex Working Capital Cash flow for terminal value Discount rate does not reflect risk Long-term growth rate too high 30
EBITDA (Cash Flow on Right Scale) Revenue (EBIT on Right Scale) Income Approach: DCF Example Example Company - Discounted Cash Flow Analysis Revenue and EBIT ($ millions) Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Operations Revenue 318,240 326,400 330,480 338,640 342,720 Gross Margin 108,202 114,240 118,973 120,217 121,666 Indirect costs (55,510) (56,856) (57,529) (58,876) (59,549) EBITDA 52,692 57,384 61,444 61,342 62,117 Depreciation (15,912) (16,320) (15,524) (15,932) (15,136) EBIT 36,780 41,064 45,920 45,410 46,981 Discretionary Cash Flow EBIT 36,780 41,064 45,920 45,410 46,981 Tax on EBIT at 35.00% (12,873) (14,372) (16,072) (15,893) (16,443) Depreciation 15,912 16,320 15,524 15,932 15,136 Capital expenditiures (18,000) (12,500) (18,000) (13,000) (15,000) Change in non-cash w orking capital (1,591) (1,632) (1,652) (1,693) (1,714) After tax unlevered discretionary cash flow 20,228 28,880 25,719 30,755 28,960 400 350 300 250 200 150 100 50 - Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 50 45 40 35 30 25 20 15 10 5 - Discount period 0.5 1.5 2.5 3.5 4.5 Discount at WACC of 10.00% 0.9535 0.8668 0.7880 0.7164 0.6512 Present value 19,286 25,032 20,266 22,031 18,860 EBITDA and Cash Flow ($ millions) Terminal value, grow ing at 2.00% 229,268 PV accumulation 6% 13% 19% 26% 32% Total Enterprise Value (TEV) 334,745 70 60 35 30 Selected Range 315,000 to 355,000 50 25 Year Over Year Change 40 20 Total Revenues n.a. 2.6% 1.3% 2.5% 1.2% Indirect Costs n.a. 2.4% 1.2% 2.3% 1.1% 30 15 20 10 Ratios Gross margin 34.0% 35.0% 36.0% 35.5% 35.5% EBITDA margin 16.6% 17.6% 18.6% 18.1% 18.1% EBIT margin 11.6% 12.6% 13.9% 13.4% 13.7% Depreciation / Revenue 5.0% 5.0% 4.7% 4.7% 4.4% 10 - Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 5-31
Some Examples
Incorrect Use of Comparable company multiples Background Assist audit in annual impairment review Client performed analysis Concluded no impairment based on high end value Key Issue(s) Inappropriate use of comparable company multiples? Process Analyzed comparable companies Studies historical performance Outcome Red flag for a potential Write down 33
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Aggressive Assumptions Overview Background Retained by investor to value target for investment purposes Client developed aggressive projections Had a view on value/price Key Issue(s) What was the support for the projections? Process Analyzed historical performance Studied industry growth expectations Outcome One-half of value supported 36
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Discounted Cash Flow Analysis - Unadjusted Projections 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Residual Operations Revenue 3,968 5,283 7,342 8,905 14,896 24,062 37,218 50,512 65,051 84,524 87,060 Gross Margin 1,085 1,329 1,685 3,130 6,565 11,681 18,555 26,076 34,337 44,785 Direct and Indirect costs (1,085) (1,227) (1,442) (3,024) (5,698) (10,350) (13,435) (17,394) (22,054) (28,238) EBITDA - 102 243 106 867 1,331 5,120 8,682 12,283 16,547 Depreciation (759) (831) (919) (1,011) (1,121) EBIT Revenues ($000s) 572 4,289 7,763 11,272 15,426 Discretionary Cash Flow EBIT 90,000 80,000 572 4,289 7,763 11,272 15,426 15,889 Tax on EBIT at 34.00% 70,000 (194) (1,458) (2,639) (3,832) (5,245) (5,402) Depreciation 60,000 759 831 919 1,011 1,121 Capex 50,000 (848) (1,400) (1,400) (1,400) (1,400) 40,000 Change in non-cash working capital (75) 96 (453) (611) (1,161) - 30,000 After tax unlevered discretionary cash flow 213 2,358 4,190 6,440 8,741 10,487 20,000 10,000 Discount period 0.5 1.5 2.5 3.5 4.5 4.5 0 Discount at WACC of 30.00% 0.8771 0.6747 0.5190 0.3992 0.3071 0.3071 Present value 187 1,591 2,175 2,571 2,684 Residual value, growing at 3.00% 11,569 PV accumulation 1% 9% 19% 31% 44% 44% Total Enterprise Value (TEV) 20,776 187 1,778 3,952 6,523 9,207 9,207 Year Over Year Change Revenue 31.4% 33.2% 39.0% 21.3% 67.3% 61.5% 54.7% 35.7% 28.8% 29.9% EBITDA nm nm 139.5% nm 716.9% 53.4% 284.7% 69.6% 41.5% 34.7% Ratios Gross margin 27.3% 25.1% 23.0% 35.2% 44.1% 48.5% 49.9% 51.6% 52.8% 53.0% EBITDA margin 0.0% 1.9% 3.3% 1.2% 5.8% 5.5% 13.8% 17.2% 18.9% 19.6% EBIT margin 2.4% 11.5% 15.4% 17.3% 18.3% Depreciation / Revenue 3.2% 2.2% 1.8% 1.6% 1.3% 37
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Discounted Cash Flow Analysis - Adjusted Projections 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Residual Operations Revenue 3,968 5,283 7,342 8,905 14,896 20,110 26,143 31,371 37,646 45,175 46,530 Gross Margin 1,085 1,329 1,685 3,130 6,565 9,049 11,764 14,117 18,823 22,587 23,265 Direct and Indirect costs (886) (1,227) (1,442) (3,024) (5,698) (7,692) (9,615) (11,538) (13,846) (16,615) (17,113) EBITDA 200 102 243 106 867 1,357 2,149 2,579 4,977 5,972 6,152 Depreciation (603) (784) (627) (753) (903) EBIT Revenues $000s 754 1,365 1,952 4,224 5,069 Discretionary Cash Flow EBIT 90,000 80,000 754 1,365 1,952 4,224 5,069 5,221 Tax on EBIT at 34.00% 70,000 (256) (464) (664) (1,436) (1,723) (1,775) 60,000 Depreciation 603 784 627 753 903 903 50,000 Capex (1,149) (1,126) (784) (1,255) (1,506) (547) 40,000 Change in non-cash working capital 30,000 (513) (632) (548) (657) (789) (142) After tax unlevered discretionary cash flow (561) (73) 583 1,629 1,954 3,661 20,000 10,000 Discount period 0.5 1.5 2.5 3.5 4.5 4.5 - Discount at WACC of 20.00% 0.9129 0.7607 0.6339 0.5283 0.4402 0.4402 Present value (512) (56) 370 860 860 Residual value, growing at 3.00% 9,196 PV accumulation -5% -5% -2% 6% 14% 14% Total Enterprise Value (TEV) 10,719 (512) (567) (197) 663 1,523 1,523 Year Over Year Change Revenue 31.4% 33.2% 27.9% 21.3% 24.3% 35.0% 30.0% 20.0% 20.0% 20.0% EBITDA nm nm 139.5% nm 716.9% 56.5% 58.3% 20.0% 93.0% 20.0% Ratios Gross margin 27.3% 25.1% 23.0% 35.2% 44.1% 45.0% 45.0% 45.0% 50.0% 50.0% EBITDA margin 5.0% 1.9% 3.3% 1.2% 5.8% 6.7% 8.2% 8.2% 13.2% 13.2% EBIT margin 3.7% 5.2% 6.2% 11.2% 11.2% Depreciation / Revenue 3.0% 3.0% 2.0% 2.0% 2.0% 38
Rate of Return
Discount Rate Illustrative WACC calculation Low High US real risk free rate 2.6% 2.6% Long term inflation differential between the UAE and the US 0.5% 0.5% Implied risk free rate for the UAE 3.1% 3.1% Unlevered beta 1.0 1.0 Debt-to-equity 35% 35% Levered beta 1.4 1.4 Implied risk premium for mature market 6.0% 6.0% Country risk premium - UAE 1.0% 1.0% Specific risk premium 2.0% 4.0% Cost of equity 14% 16% After tax cost of debt 10% 12% Debt 25% 25% Equity 75% 75% WACC (rounded) 13% 15% Key Data Sources Government bond/ treasury bond Risk free rate Ibbotson Associates Size Premium Industry Premium Equity Risk Premium Prof. A Damodaran Website Industry Premium Beta Capital IQ, Bloomberg, Mergerstat Informed judgment 40
Key Take-away
Common Valuation Shortcomings Very mathematical - Valuation is an art not a precise science Lack of corroboration - Reliance on a single valuation method No risk adjustment - Reliance on historical results and forecasts Use of average market multiples Terminal value calculations different methods than DCF, uncertainty, growth factor, etc. Lack of parity in cash flows and discount rates. e.g. using WACC to discount after interest cash-flows, pre-tax vs. post-tax amounts, etc. Incorrect adjustments - Normalization adjustments (owner vs. management), cash-flow adjustments (working capital), WACC (risk factor to cater for uncertainty of achieving forecast), value of debt to deduct from enterprise value, etc. 42
Key Take-away Value versus price Reasonability checks Compare apples to apples Price is what you pay. Value is what you get. Warren Buffett What to spend time on Business and industry outlook Business and industry key success factors Strategic factors for a transaction Risks & opportunities identification Interpretation of the data What not to spend time on Complex models Too much precision (not an exact science) Irrelevant scenario and sensitivity analysis
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