Valuation for merger and

acquisition
March 2015

Flow of presentation
Valuation methodologies
Valuation in the context of Merger and Acquisition
Indian Regulatory Environment and Minority Interest
Safeguard

Valuation methodologies

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Valuation methodologies Business / Share

Asset based

Cash flow based

Book Value

Discounted Cash
Flow
Free cash flow to
firm (FCFF)
Free cash flow to
equity (FCFE)

Replacement Cost

Market based
Quoted Market Price
Comparable Listed
Multiples
Comparable
Transaction Multiples

Applicability of a particular methodology guided by:

Nature of industry
Stage of company (nascent / growth or mature)
Listed / unlisted In case of listed, whether frequently traded or not

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Asset Based Methodologies- Net Assets/

Replacement Value
Arrives at valuation of an entity in terms of Tangible Net Worth of the
entity as at valuation date
Issues Involved

Limitations

Fixed Assets Revalued or Book

Value?

Current Assets - Cost or

Realizable Value

Differences in Accounting Policies

in case of Merger or Relative
Valuations

Adjustments for Contingent

Liabilities

Fails to factor the value of

intangible assets like brands,
technical know-how,
distribution network etc.

Impacted by accounting

Assumes assets always

have profit generating value

Ignores Returns vs. Cost of

capital

Generally Not Suitable for Fair Valuation of Going Concerns

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Is NAV completely doomed?

Not really

A Loss-making
Company

A Company Making
Inadequate Return
on Capital

A Real-Estate
Company

Any Company
Facing Potential
Liquidation

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Comparable Multiple Method

Methodology involves three elements:

Comparable Companies

assessment of maintainable earnings

application of an appropriate multiple of comparable companies
identification and valuation of any surplus assets or liabilities
Global vs. Indian comparisons
Identifying direct comparables: Research on companies is the key
Accounting for size differentials
Accounting for differing operating conditions

Choice of multiples

Transaction vs. Stock Market Multiples

Sales vs. Profitability Multiples Vs. Capacity Multiples
Historical vs. Forward Multiples

Valuers judgment required for appropriate choice

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Choice of multiples
Sector

Multiple Used

Rationale

Manufacturing

EV/EBITDA

Often with normalized earnings

Growth firms

PEG ratio

Big differences in growth rates

Young growth firms with

losses

Revenue Multiples

What choice do you have?

Infrastructure

EV/EBITDA, Price/ Book equity

depending on industry and capital
structure

EV/EBITDA - Normalized profits can

be reasonably determined;
P/BV Since most of them are
capital intensive

Financial Services

Price/ Book equity

Marked to market

Retailing

Revenue multiples

Margins equalize sooner or later

Oil &Gas, Mining

Resource multiples (EV/resource)

Cash flows are directly related to

resources

Choice of multiple depends on the sector in which

the Company operates
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Comparable Multiple Method

Issues Involved

Identifying Comparable Set of

Companies
Difference in Size, Margins,
Operating Efficiencies
Differences in Accounting Policies/
Leveraging Risks

Limitations

Markets may not necessarily

value companies fairly at all
points of time
Adequate and reliable details for
transaction
multiples
not
available in most of the cases

Provides a good benchmark to test reasonableness

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Discounted Cash Flow (DCF) Method

Determines the net present value of underlying cash flows of the business

Not Impacted by accounting principles, as based on cash flows and not

book profits

Incorporates all factors relevant to business e.g.

Tangible and intangible assets

Current and future competitive position

Financial and business risks

Business Value = NPV (FCFs) = NPV (NOPLAT Incremental WC

Incremental Capex)

Considered to be the most logical method of valuation

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Equity versus firm

Equity valuation

Values the claims of the equity shareholders on the business

Operating cashflows are considered and adjusted for movements in debt (debt
taken, repaid and interest)
Discount rate used should only be the cost of equity capital
Appropriate when the company has stable leverage

Firm valuation

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Values the claims of the all the stakeholders (debt and equity) on the business
Operating cashflows are considered but movements in debt (debt taken, repaid
and interest) are not taken into consideration
Discount rate used should only be the weighted average cost of capital (equity +
debt)
Appropriate when the company has unstable leverage

DCF Method Some key points

Valuation is at a particular date- the valuation date

Preferably the date nearer to the date of the valuation workings

Cash Inflows

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Remember to take out non- operating cash flows

Non operating cash flows are best valued as surplus asset (discussed later)
Examples Interest on surplus funds, dividends, profit on sale of fixed assets
investments, liability write offs

DCF Method Some key points.. Contd.

Cash Outflows
Incremental working capital aligned with sales growth

Working capital improvements are possible, but difficult

Extremely important matter for high working capital companies

Sugar seasonal variations. Does EV include working capital?

Capital Expenditure

Incremental for Growth

Dont underestimate maintenance capex

Especially without margin adjustments

May not be immediate

Gross Asset value/ Asset life is a broad benchmark. However, cannot ignore technological
obsolescence

Income tax

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Is on PBIT (because WACC assumes post tax debt cost)

Actual rate for explicit period; Adjusted for future
Stretch explicit period till exemption periods are over; Or value tax benefits
separately

Weighted average Cost of Capital (WACC)

Discounting rate WACC
The Rate of Return that an Investor would require to be induced to invest in the
stream of future cash flows being discounted
Weighted Average

Cost of Capital

= Re X (E/(D+E)) + Rd x (1-t) X (D/(D+E))

Cost

The

of Debt Weighted average cost of debt

Debt- Equity weights are market based and not book based

One of the most important causes for Over valuation

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Some key points

Discount rate used should be consistent with both the riskiness and
the type of cashflow being discounted.

Equity versus Firm: cash flows to equity should be discounted with cost of
equity. Cash flows to the firm should be discounted with the cost of capital.
Currency: The currency in which the cash flows are estimated should also
be the currency in which the discount rate is estimated- USD discount rate
can not be used for rupee cash flows or vice versa
Nominal versus Real: For real cash flows (i.e., excluding inflation), the
discount rate should be real

More logical to use mid year discount rate

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Perpetuity Value/ Terminal Value

Perpetuity

value is the projected value of the business at

the end of the outlook period
It represents a means of obtaining a proxy for the value of
the future cash flows of the business after the end of the
outlook period

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Common Approaches to Perpetuity Value

Cash Flow approach (Gordon Growth method)

Take

forecast net cash flow for the last year of the outlook period
Divide above amount by r-g
r = Discount rate to be utilized
g = Long term forecast average annual rate of growth after outlook period

Capitalization of earnings/Exit multiple approach

Estimate

future maintainable annual EBITDA after the outlook period

Select an appropriate EBITDA multiple to apply to those earnings

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Adjustment for surplus assets and

contingent liabilities

Surplus assets Key characteristics

Not used for generation of profitability

Purchased out of past cash flows

Usually land/ properties/ investments

Be careful to separate surplus cash from operating cash

When an asset is surplus, any return generated by it should not be included in

operating cash flows

Contingent liabilities

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Usually tax cases

Good idea to take expert advice

DCF : Strengths and Limitations

Strengths

Limitations

Theoretically correct

Volume and complexity of assumptions

Forward looking

Adequacy of data

Incorporates risk and time value of

money

At times, extremely sensitive to small

changes in assumptions

Focuses on cash returns

Developing an understanding of the business is the key to a good DCF

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Valuation, Really a Call on Three factors..

Risk

Growth
How Much? How
Sustainable?

External/Internal Price
Risk

How Long?

Manageable/ Non
manageable
Mitigating Factors
Brand, Distribution
Value

Management Quality
Reputation, Competence, Vision, Corporate Governance
Premium to HDFC Bank
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Valuation in the context of Merger and

Acquisition

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Merger and Acquisition- Situations

Merger/Demerger
Merger

involves absorption of one company by another or amalgamation of two

companies to form a new company

Consolidation of businesses / entities to take synergy benefits

Demerger

involves transfer of identified business from one company to another

Vertical split of the company usually for Inviting investor in identified business

Acquisition
Business

slump sale/itemized sale

Usually for expansion of existing business

Share

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purchase

purchase

Focus on inorganic growth /strategic or non strategic investments

Valuation for merger and acquisition

Mergers

Relative value of their shares - rather than absolute value.

Value is determined

on going concern basis

on as is where is basis post merger synergies/benefits not to be considered

Demerger

Usually not required when demerged into wholly owned subsidiary/ company with
mirror shareholding

But if the demerger is into an existing operating entity, valuation is required

Acquisitions

Absolute valuation of shares- not relative valuation

Value is determined -

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on going concern basis

post merger synergies/benefits are considered

Swap ratio for merger / demerger

Since scheme of arrangement is filed in a court of law, it is generally accepted

to also give weight to NAV method even though it may not be the most
appropriate method

Supreme court HLL case (HLL and TOMCO merger)

Combination of three methods - NAV, Market Price and Earnings Capitalization
(comparable multiples)
Weights to different methods:
NAV
: 20%
Market price
: 40%
Earnings
: 40%

However, these are not definitive and may be modified, depending upon the
facts and circumstances of each case. However, weights given should be
explained and justified
SEBI

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Fairness Opinion from Category 1 Merchant Banker

Acquisition valuations can depart from fair

values ..

Buyers/ Sellers leverage

Competitive Positioning
Distress Sale Vs. Desperate Buy

Strategic Premium/ Discounts: Strategic Premium / Discount arises on

account of

Operational synergy- Incremental Revenues/ cash Flows

Financial synergy- reduce the debt costs
Loss in value to acquirer in case target is acquired by competition
Ability of acquirer to cut costs in the acquired company

Higher the quality of management, lower the scope for cutting costs

Same target can have different value in the hand of

different acquirers
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Minority Versus Controlling Interests

All things being equal, a controlling interest is worth more than a

minority interest

A holder of a minority interest generally has a passive investment and

cannot initiate a sale of assets or require a higher dividend payout

The holder of a controlling interest can influence corporate policy.

Corporate Governance is a key tool to reduce minority interest.

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The Three Levels of Value

Control Value
Control
Premium

Minority Interest
Discount

Marketable
Minority Interest Value
Marketability
Discount

Non Marketable
Minority Interest Value

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Controlling interests are

considered marketable in that
they can generally be sold.
However, controlling interests
are not marketable in the sense
of publicly traded minority
interests

Indian Regulatory Environment and Minority

Interest Safeguard

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Snapshot of Indian laws impacting M&A

Direct Tax

Indirect Tax

SEBI / SE Listing
Requirements

Accounting Standards /
GAAP

Competition Act

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Companies Act

Laws affecting
M&A
FDI & Exchange
Control

Stamp Duty

Minority interest safeguard- under

regulations especially SEBI
Valuation report from Independent
chartered accountant

May not required by CA firm if no

change in shareholding

Audit Committee approval on Scheme and

Valuation report

In addition to approval from

board of directors, BoD

Observation letter from stock exchanges

after comments from SEBI

Approval from SEBI after NOC from stock

exchanges

Majority votes from public shareholders

Additional shares allotted to

promoters*
Scheme involves listed company
and any other entity involving
promoters*
Listed company has purchased
shares of subsidiary intended to be
merged with itself, from promoters*
in the past

Required only under

three above
instances

Primarily process driven rather than controlling the valuation itself.

* Includes promoter group, related parties of promoter / promoter group, associates / subsidiaries of promoter / promoter group

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Minority interest safeguard- Valuer and

company role

Valuer

to be independent and resist influence from the companies

Extra careful especially when M&A involves related parties (e.g. increase of
stake)
Explain key factors to the BoD and audit committee

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Methods used/methods not used

Significant business plan assumptions
Significant valuation assumptions
WACC/Discount rate
Treatment of surplus assets/contingent liabilities
Basis of selection of comparable companies, valuation multiple

Companies Act 2013: Valuation Requirements

Section

Particulars

62 (1) c

Issue of shares to a non-member

230

Corporate debt restructuring situations

232

Swap ratio for mergers

236

Purchase of minority shareholders

192

Non cash transaction involving Directors

281/305/319/325

Winding up of company situations

Valuation to be done by Registered Valuer. However, Registered

Valuer Guidelines are still to be notified

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To sum up

Valuation, like beauty, lies in the eyes of the beholder

And like beauty, our perception of value changes

Depending upon situations, valuation can be Exactly

Wrong
or
Roughly correct (if you are lucky)

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Questions?