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CORPORATE VALUATION
WHY REASONABLE
• REGULATED INDUSTRIES
ADJUSTMENTS TO BOOK VALUE
• TO REFLECT REPLACEMENT COST
• TO REFLECT LIQUIDATION VALUE
Centre for Financial Management , Bangalore
BALANCE SHEET OF HORIZON LIMITED AS ON
MARCH 31, 2001 ( Rs in million)
CAPITAL AND LIABILITIES ASSETS
SHARE CAP 15.0 FIXED ASSETS 33.0
RES. AND SURP 11.2 INVESTMENTS 1.5
LOAN FUNDS 21.2 CURRENT ASSETS 23.4
CURR LIAB 10.5
57.9 57.9
• PUBLICLY TRADED
• WHAT PRICE ?
AVERAGING ?
EMH . . .
• TWO IMPLICATIONS
• S & D . . MOST RELIABLE ESTIMATE OF
VALUE
• SECURITIES . . VALUED . . LIEN DATE
Centre for Financial Management , Bangalore
DIRECT COMPARISON APPROACH
Common sense and economic logic tell us that similar assets should
sell at similar prices. Based on this principle, one can value an asset
by looking at the price at which a comparable asset has changed
hands between a reasonably informed buyer and a reasonably
informed seller. This approach, referred to as the direct comparison
approach, is commonly applied in real estate.
Essentially, the direct comparison approach is reflected in a simple
formula:
Vc
VT = xT . (32.1)
xc
where VT = appraised value of the target firm (or asset)
xT = observed variable for the target firm that supposedly
drives value
Vc = observed value of the comparable firm
x = observed variable
Centre forManagement
for Financial the comparable
, Bangalore company
STEPS IN APPLYING THE
DIRECT COMPARISON APPROACH
Operationally, a top-down procedure may be followed in applying
the direct comparison approach. This involves the following steps:
• Analyse the economy
• Analyse the industry
• Analyse the subject company
• Select comparable companies
• Analyse subject and comparable companies
• Analyse multiples
• Value the subject company
MULTIPLES
• PRICE TO SALES
• PRICE TO EBDIT
• PRICE TO EBIT
• PRICE TO EARNINGS
A B C
PBDIT* 12 15 20
Book value of assets * 75 80 100
Sales * 80 100 160
Market value * (MV) 150 240 360
MV/PBDIT 12.5 16.0 18.0
MV/Book value 2.0 3.0 3.6
MV/Sales 1.9 2.4 2.3
*
In million rupees
Centre for Financial Management , Bangalore
ILLUSTRATION .
statements.
• Calculating the free cash flow and the cash flow available
to investors
1 2 3
Equity capital 60 90 90
Reserves & surplus 40 49 61
Debt 100 119 134
Total 200 258
285
Fixed assets 150 175 190
Investment - 20 25
Net current assets 50 63 70
Total 200 258
285
The free cash flow (FCF) is the post-tax cash flow generated from the operations of the
firm after providing for investments in fixed investment and net working capital
required for the operations of the firm. FCF can be expressed as:
FCF = NOPLAT - Net investment
FCF = (NOPLAT + Depreciation) - (Net investment +
Depreciation)
FCF = Gross cash flow - Gross investment
Exhibit shows the FCF calculation for Matrix Limited
Matrix Limited Free Cash Flow
Year 1 Year 2 Year 3
NOPLAT 25.2 30.0 27.0
Depreciation 12 15 18
Gross cash flow 37.2 45 45
(Increase)/decrease in 13 7
working capital
Capital expenditure 40 33
Gross investment 53 40
Free cash flow (8) 5
CASH FLOW AVAILABLE TO
INVESTORS
Growth rate
= Invested capital x ROIC x 1 -
ROIC
Thus, invested capital, ROIC, and growth rate are the basic drivers of FCF. The
drivers of FCF for Matrix Limited for the years 2 and 3 are given below:
Year 2 Year 3
NOPLAT
• ROIC = 15.00% 11.3 %
Invested capital
Net investment
• Growth rate = 19.00% 9.2%
Invested capital
• FCF -Rs.8 million Rs.5 million
Centre for Financial Management , Bangalore
DEVELOPING THE ROIC TREE
As ROIC is a key driver of free cash flow and valuation, it is useful to develop the
ROIC tree which disaggregates ROIC into its key components. The starting point of the
ROIC tree is:
NOPLAT
ROIC =
Investment
Since NOPLAT is equal to EBIT times (1-cash tax rate), ROIC can be expressed as
pre-tax ROIC times (1-cash tax rate):
EBIT
ROIC = (1- Cash tax rate)
Invested capital
Pre-tax ROIC can be broken down into two components as follows:
EBIT EBIT Revenues
= x
Invested capital Revenues Invested capital
Operating Capital
Margin turnover
The first term, viz, operating margin measures how effectively the firm converts
revenues into profits and the second term, viz, capital turnover reflects how effectively
the company employs its invested capital. Each of these two components can be further
disaggregated. Exhibit 32.6 shows the ROIC tree for Matrix Limited.
Matrix Limited – ROIC Tree for Year 3
1. Develop the revenue forecast on the basis of volume growth and price
changes.
2. Use the revenue forecast to estimate operating costs, working capital, and
fixed assets.
3. Forecast non-operating items such as investments, non-operating income,
interest expense, and interest income.
4. Project net worth. Net worth at the end of year n is equal to net worth at the
end of year n-1, plus the amount ploughed back from the earnings of year
n, plus new share issues during year n, minus share repurchases during year
n.
5. Use the cash and / or debt account as the balancing account.
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Projected Profit and Loss Account and Balance Sheet for Matrix Limited for
Five Years – Years 4 through 8 – The Explicit Forecast Period
Rs. in million
The final step in the forecasting exercise is to evaluate the forecast for consistency and
alignment by asking the following questions.
• Is the projected revenue growth consistent with industry growth?
• Is the ROIC justified by the industry’s competitive structure?
• What will be the impact of technological changes on risk and returns?
• Is the company capable of managing the proposed investments?
• Will the company be in a position to raise capital for its expansion
needs?
Because ROIC and growth are the key drivers of value, let us look at how companies
have performed on these parameters. Empirical evidence suggest that:
• Industry average ROICs and growth rates are related to economic fundamentals.
For example, the pharmaceutical industry, thanks to patent protection, enjoys a
higher ROIC whereas the automobile industry earns a lower ROIC because of its
capital intensity.
• It is very difficult for a company to out perform its peers for an extended period of
time because competition often catches up, sooner or later.
Present value of cash flow during + Present value of cash flow the
explicit forecast period after the explicit forecast period
• Market-to-book ratio
method
This method assumes that the free cash flow would grow at a constant
rate for ever, after the explicit forecast period, T. Hence, the continuing
value of such a stream can be established by applying the constant
growth valuation model:
FCFT+1
CVT = (32.2)
WACC – g
where CVT is the continuing value at the end of year T, FCFT+1 is the
expected free cash flow for the first year after the explicit forecast
period, WACC is the weighted average cost of capital, and g is the
expected growth rate of free cash flow forever.
This method too uses the growing free cash flow perpetuity formula but
expresses it in terms of value drivers as follows:
NOPLATT+1 (1 – g / r)
CVT = (32.3)
WACC – g
where CVT is the continuing value at the end of year T, NOPLATT+1 is
the expected net operating profits less adjusted tax for the first year after
the explicit forecast period, WACC is the weighted average cost of
capital, g is the constant growth rate of NOPLAT after the explicit
forecast period, and r is the expected rate of return on net new
investment.
The formulae given in Eqns (32.2) and (32.3) produce the same result
as they have the same denominator, and the numerator in Eqn (32.3) is a
different way of expressing the free cash flow (the numerator of Eqn
(32.2).
Centre for Financial Management , Bangalore
REPLACEMENT COST METHOD
The growing free cash flow perpetuity method is commonly used for
estimating the continuing value. The key inputs required for this method
are the weighted average cost of capital (WACC) and the constant
growth rate (g). The WACC has been estimated at 14 percent. If we
assume that g is 10 percent, the continuing value of Matrix Limited at
the end of year 8 can be calculated as follows.
FCF9 FCF8 (1 + g)
Continuing value8 = =
WACC - g WACC - g
16 (1.10)
= = Rs.440 million
0.14 - 0.10
396.1 1
PV (TV) = x = 2188.23
0.15 - 0.06 (1.15)5
FIRM VALUE = 397.44 + 2188.23 = 2585.67 M
Centre for Financial Management , Bangalore
The three- stage growth model may be illustrated with an example. Multiform
Limited is being appraised by an investment banker . The following information has
been assembled
Base Year (Year 0) Information
• Revenues = Rs.1000 million
• EBIT = Rs.250 million
• Capital expenditure = Rs.295 million
• Depreciation and amortisation = Rs.240 million
• Working capital as a percentage of revenues = 20 percent
• Tax rate = 40 percent( for all time to come)
Inputs for the High Growth Period
• Length of the high growth period = 5 years
• Growth rate in revenues, depreciation, = 25 percent
• EBIT, and capital expenditures
• Working capital as a percentage of revenues = 20 percent
• Cost of debt = 15 percent (pre-tax)
• Debt-equity ratio = 1.5
• Risk free rate = 12 percent
• Market risk premium = 6 percent
• Equity beta = 1.583
• WACC= 0.4 [12 + 1.583(6)] + 0.6 [15(1-0.4)] = 14.00 percent
Centre for Financial Management , Bangalore
Inputs for the Transition Period
• Length of the transition period = 5 years
• Growth rate in EBIT will decline from 25 percent
in year 5 to 10 percent in year 10 in linear move-
ments of 3 percent each year
• Working capital as a percentage of revenues = 20 percent
• The debt-equity ratio during this period will drop
to 1:1 and the pre-tax cost of debt will be
14 percent
• Risk - free rate = 11 percent
• Market risk premium = 6 percent
• Equity beta = 1.10
• WACC = 0.5 [11 + 1.1(6)] +0.5 [14 (1-0.4)]
= 13.00 percent
Inputs for the Stable Growth Period
• Growth rate in revenues , EBIT, capital
expenditure, and depreciation = 10 percent
• Working capital as a percentage of revenues = 20 percent
• Debt-equity ratio = 0:1
• Pre-tax cost of debt = 12 percent
• Risk free rate = 10 percent
• Market risk premium = 6 percent
• Equity beta = 1.00
• WACC = 1.0 [ 10+1 (6)] = 16.00 percent
Centre for Financial Management , Bangalore
FCF FORECAST: MULTIFORM
LIMITED
COMPARABLE COMPANIES
• CURRENT EARNINGS ARE REFLECTIVE OF FUTURE EARNINGS
CAPACITY
• COMPANY EXPECTS STABLE GROWTH
• PRESENCE OF COMPARABLE COMPANIES
the cost of capital, (d) determining the continuing value at the end of the
explicit forecast period, and (e) calculating the firm value and interpreting
results.
• There are two simplified versions of the DCF approach which are commonly
used: the 2-stage growth model and the 3-stage growth model.
• If you are interested in determining the equity value, you can look at the free
cash flow to equity (FCFE) and discounting the same at the cost of equity.
• The important guidelines that an appraiser should bear in mind while
valuing a company are as follows: (i) Understand how the various
approaches compare. (ii) Use at least two different approaches. (iii) Look
at a value range. (iv) Go behind the numbers. (v) Value flexibility. (vi)
Blend theory with judgment. (vii) Avoid reverse financial engineering. (viii)
Beware of possible pitfalls. (ix) Adjust for control premia and non-
marketability factor. (x) Debunk the myths surrounding valuation.
Centre for Financial Management , Bangalore