2.

Valuation Application
• Equity / Business Valuation
- Analysis of Business Environment
- Entity’s Business Strategy Analysis
- Business Combinations- Amalgamation, Merger, Demerger, Arrangement & Restructuring
- Forecasting
- Cash flow Analysis
- Appropriate Cost of Capital / Rate of Return
- Valuation Adjustments

Introduction

Valuation process
Valuation process broadly involves the following steps:

The first step involved in the valuation process is to understand the purpose for which
valuation is required and use of the valuation.

The second step is to determine the standard of value to be used and premise of valuation
on which the valuation is required to be carried out.

The third step is to perform Industry and competitive analysis, together with an analysis of
financial information and other disclosures of the subject company.

The fourth step is to consider all the approaches of valuation and select the most appropriate
approaches of valuation.

The fifth step is to apply the valuation approaches through suitable valuation methodologies
and derive the value.

In last step the derived value is adjusted for the discount or premium if applicable and the
valuation report is communicated in writing.

INDUSTRY ANALYSIS
Industry analysis helps in understanding the competitive dynamics of an industry and in
assessment of profitability of an Industry. It helps in getting a sense of what is happening in
an industry, competition within the industry and effect of competition caused by other
emerging Industries and understand. Therefore it provides a guideline for the future of the
subject company.

There are many factors pertaining to industries which valuer should focus performing
valuation of the subject company belonging to a particular industry. Discussion of each of
these features follows:

1. Industry Life Cycles

Every industry is passing through different stages in its life cycle. Many industrial
economics believe that the development of almost every industry may be analysed in
terms of its life cycle. The life of an industry can be separated as under:

 Embryonic
 Growth
 Shakeout
 Mature
 Decline

Each of stage and its characteristics can be depicted through the figure given below:
So the first step in industry analysis is to determine what stage of growth through which the
industry is passing at present. This approach will also be useful in analyzing the past and
forecasting the future of an industry.

2. Sensitivity to the business cycles: Industries are not equally sensitive to the
business cycle changes. Some industries like FMCG, Pharmaceuticals etc. are virtually
independent of the business cycle as the demand for the products of these sectors is
regular in nature and hardly affected by the state of the macro economy and business
conditions. But sectors like Real estate, Automobiles etc. are highly sensitive to the
business cycle. Mainly three factors shall determine the sensitivity of an industry’s
earnings to the business cycle.

 Sensitivity of sales is the prime factor which determines the earnings efficiency of an
industry at different stages in business cycles. The industries vary in their sensitivity
to the business cycle. The sales of firms in industries that sell necessities will show
little sensitivity to business conditions. Consumer care products and entertainment are
industries with low sensitivity and for which income is not a crucial determinant of
demand. On other hand steel, auto and transportation industries are highly sensitive
to the state of the economy.

 Operating leverage also helps in determining the sensitivity to business cycles.

Operating leverages is the ratio of fixed cost to variable cost. Firms with greater
amount of variable as opposed to fixed costs will be less sensitive to the business
conditions whereas the firm with higher amount of fixed cost will be highly sensitive
to the business condition.

 Financial leverages refer to presence of debt capital in the capital structure of the
Company. Interest on debt is to be paid regardless of the sales level. Interest to be
paid on the debt is in the nature of fixed cost and increases the sensitivity of profit to
business conditions.
 3. Profit potential of Industries: Industrial companies are engaged in the production
and sale of commodities and services under competitive conditions. There are many
factors which impel competition in an industry and decide its strength or weakness.
So valuer shall take effort to understand the industry context in which the firms
operates thereby he can reach a rational judgment as to its profit potentials.

4. Industry structure and characteristics: In an industry analysis number of key

characteristics should be considered by the Valuer. Some of them are as under:

 Structure of industry and nature of competition: This can be determined by

concentrating on the number of competing firms, industry leaders, entry barriers,
pricing policies of firms, product differentiation, competition from foreign firms,
product features of substitutes available etc.

 Nature and prospects of demand: In order to understand the nature and prospects of
demand for products in an industry one should identify the major customers and their
requirements, key determinants of demand, degree of cyclicality in demand, expected
rate of growth in the future etc.

 Cost structure, efficiency and profitability of industry: This could be measured by

proportion of key cost elements, labor productivity, liquidity conditions, profit margins,
return on investments and earning power etc.

 Technology and research: Importance shall be given to degree of technological

stability, technological changes, Research and Development expenses as a industry
sales, the proportion of sales growth attributable to new products etc.

TOOLS TO PERFORM INDUSTRY ANALYSIS

PEST Analysis: A PEST analysis stands for: Political-, economic-, socio-cultural- and
technological factors. These areas are listed, analyzed and related to the subject company.
The purpose of this is to get an impression of how the environment is going to change in the
future.
Political factors (P): these cover various forms of government interventions and political
lobbying activities in an economy.
Economic factors (E): these mainly cover the macroeconomic conditions of the external
environment, but can include seasonal/ weather considerations.
Social factors (S): these cover social, cultural and demographic factors of the external
environment.
Technological factors (T): they include technology related activities, technological
infrastructures, technology incentives, and technological changes that affect the external
environment.
 Political Factors Economic Factors

PEST
ANALYSIS

Social Factors Technological Fcators

However, it must be kept in mind that a PEST analysis first and foremost builds on historical
data and it becomes more difficult to predict the future from past events. Further it must be
acknowledged that the results from the PEST analysis are not directly transferable to the
future. For this reason, the factors in the PEST analysis will be divided into three time periods.

The first being an analysis of past events (the last 5-7 years), corresponding to the historical
financial analysis and last two time periods deal with the future. In order to predict the future
accurately, the analysis is divided into the short run and the long run. Lastly, the factors will
be quantified on a scale from 1 to 5 (1 being the most favorable for subject Company). This
should simplify the comparison between factors and further make past and future events
comparable. PEST analysis has an extended form known as PESTEL analysis in which two
extra factors i.e. Environmental and Legal are included and analyzed in order to get effect of
these factors on the industry.

Porters Five Force Model: The Porter’s 5 Forces is often used as a model for describing an
industry. The model is very useful in describing the relation between the company in focus,
its competitors and its suppliers. This theory is based on the concept that there are five forces
that determine the competitive intensity and attractiveness of a market. Porter’s five forces
help to identify where power lies in a business situation. This is useful both in understanding
the strength of an subject company’s current competitive position, and the strength of a
position that an subject company’s may look to move into. The five forces are:

1. Supplier power: An assessment of how easy it is for suppliers to drive up prices. This is
driven by the:

 number of suppliers of each essential input

 uniqueness of their product or service
 relative size and strength of the supplier
 cost of switching from one supplier to another

2. Buyer power: An assessment of how easy it is for buyers to drive prices down. This
is driven by the:

 number of buyers in the market

  importance of each individual buyer to the organisation
 cost to the buyer of switching from one supplier to another. If a business has
just a few powerful buyers, they are often able to dictate terms.

3. Competitive rivalry. The main driver is the number and capability of competitors in
the market. Many competitors, offering undifferentiated products and services, will
reduce market attractiveness.
4. Threat of substitution. Where close substitute products exist in a market, it
increases the likelihood of customers switching to alternatives in response to price
increases. This reduces both the power of suppliers and the attractiveness of the
market.
5. Threat of new entry. Profitable markets attract new entrants, which erodes
profitability. Unless incumbents have strong and durable barriers to entry, for
example, patents, economies of scale, capital requirements or government policies,
then profitability will decline to a competitive rate.

The model works by assessing each of these categories and their relative power in relation to
the subject company. For each of the 5 forces, opportunities and threats are quantified by
scaling them from 1-5, where 1 is a favorable position and 5 is unfavorable. Furthermore the
quantification is divided into 3 categories; the past, the short-run and the long-run. This is
done in order to make the model less static and ease up the development of forecast drivers.

SWOT Analysis: SWOT is an industry analysis tool that helps the valuer to identify Strengths,
Weaknesses, Opportunities and Threats of a business or project within an industry. Strengths
and Opportunities are the key to identifying comparative advantages within an organization,
and Weakness and Threats stem from external pressure.

The SWOT analysis template is normally presented as a grid, comprising four sections.
 Strengths Weakness

Opportunities Threats

Strengths: Strength refers to a positive, favorable and creative characteristic. These are
tangible and intangible attributes (internal to an organization). Strengths should be from
both: an internal perspective and external customers. It is a distinctive competence which
gives the subject company a comparative advantage in the marketplace. Some of the factors
that may provide strength are:

Competitive advantage
Unique Selling Points
Experience, Knowledge and data
Locational or Geographic advantage
Cultural, attitudinal, behavioral
Management cover, succession
Price, value, quality
Accreditations, qualifications, certifications

Weakness: Weakness refers to the situations in which the current existence and ability
capacities of subject company are weaker compared to competitors. In other words, weakness
means the aspects or activities in which Subject Company is less effective and efficient
compared to its competitors. These aspects negatively affect the performance of subject
company and weakens the it among its competitors. Consequently, the subject company is
not able to respond to a possible problem or opportunity, and cannot adapt to changes. Some
of the factors that may be helpful in assessing the Weakness of subject company are as under:

Lack of competitive strength

Reputation, presence and reach
Financials
Own known vulnerabilities
Timescales, deadlines and pressures
Cashflow, start-up cash-drain
Continuity, supply chain robustness
Effects on core activities, distraction
Reliability of data, plan predictability
Morale, commitment, leadership

Opportunities: An opportunity is a major situation in subject company’s environment and

represents the reason for firm to exist and develop. Useful opportunities can come from:
changes in competitive or regulatory circumstances, changes in government policy related to
subject company technological changes, etc. While looking at opportunities it is also good to
look at strengths and also weakness and try to find relation between them. Consider
opportunities from an external perspective.
 What good opportunities are available in the marketplace?
 What are some trends that your company can capitalize on?
 Are there any changes in technology and markets that your company can take
advantage of?
 Are there any changes in lifestyle, social patterns, etc., that your company can take
advantage of?

Threat: Threats are external factors on which the company doesn’t have control. It refers to
any change in the external environment of the subject that may potentially harm its future.
Some of the factors are as under:
 What obstacles do subject company face?
 What are competitors doing better than subject company?
 Is the change in technology threatening the position of subject company?
 What threats do weaknesses put it at risk of?
 Do changes in lifestyle, social patterns, etc., pose a threat to subject company?

Apart from analysing the industry by applying above tools, valuer must also stay current on
facts and news concerning all the industries in which the company operates, including recent
developments (e.g., management, technological, or financial). Particularly important to
valuation are any factors likely to affect the industry’s long term profitability and growth
prospects such as demographic trends.

Competitive Position of subject Company and its Competitive strategy

The level and trend of the company’s market share indicate its relative competitive position
within an industry. In general, a company’s value is higher to the extent that it can create
and sustain an advantage relative to its competition. Porter identifies three generic corporate
strategies for achieving above-average performance:

 Cost leadership: being the lowest-cost producer while offering products comparable
to those of other companies, so that products can be priced at or near the industry
average;
 Differentiation: offering unique products or services along some dimensions that are
widely valued by buyers so that the company can command premium prices
 Focus: seeking a competitive advantage within a target segment or segments of the
industry, based on either cost leadership (cost focus) or differentiation (differentiation
focus).

BUSINESS MODEL ANALYSIS

The business model describes the success factors of a business. It should be seen as the
counterpart of the figure-based part of company valuation and comprises the qualitative
characteristics of an enterprise. Extraordinary ratios are always the consequence of an
extraordinary business model. While ratios only document economic success or failure in the
past, conclusions about the future competitiveness can be drawn from the business model.
The market position of a company and the analysis of its business model aim to identify and
classify unique features and competitive advantages. The true art of company valuation lies
in the analysis of the business model. In the long run, the most important driver for a
successful business lies in a sustainable and profitable business model with a competitive
edge; in addition to solid cash flows and appropriate debt levels. Profitability, which in a way
serves as a catalyst, plays a special role: the higher the profitability, the stronger the effect
of compounded interest within the business.

Understanding the competence of business is an essential precondition for company valuation.

A detailed analysis can only be carried out if the company’s business model and products are
comprehensible. It is impossible to value a company whose future is hard to foresee.

Six types of business models are of particular interest and importance:

 makers of short-lived products with well-known brand names (e.g. Processed Food,
printer/ink)
 providers of products that always have to be/are purchased (pharma, utilities)
 companies whose products are sold at a distinct premium due to brand name, image,
technology or quality (Apple, Intel)
 providers of products that are in demand due to external influences and regulations
(Vehicle Insurance)
 businesses that have a high level of scalability, i.e. whose marginal cost is close to
zero (Pharma, Software)
 providers of the cheapest product in the market

COMPANY ANALYSIS
Historical Financial Statement Analysis: A company’s historical financial statements
generally provide the most reliable information for estimating future performance and risk
assessment. Audited financial statements are preferred. Reviewed statements, while not
providing the level of assurance of an audit, nonetheless are generally reliable since they are
prepared in accordance with GAAP and contain disclosure and notes to the accounts. However,
since the financial statements of many closely held businesses are neither audited nor
reviewed the analyst may have to rely on compiled financial statements, which provide no
level of assurance and may not contain footnote disclosure. In other cases, the valuer may
have to rely on return filed with stock exchanges or internally generated financial statements,
the quality of which may be suspect for purposes of proper financial statement analysis.

The length of historical financial statement used for analysis depends on the business of the
company however five years of historical financial statements is generally considered
sufficient for the purpose of analysis.

To facilitate proper analysis and interpretation of a company’s financial statements, these

statements should first be adjusted to reflect the economic realities of “normal” operating
conditions. The objective of normalizing historical financial statements is to present the data
on a basis comparable to that of other companies in the industry, thereby allowing the Valuer
to form conclusions as to the strength or weakness of the subject company relative to its
peers.

Ratio analysis: Ratio analysis is the most commonly used tool in financial analysis. Financial
ratios allow the valuer to assess and analyse the strengths and weaknesses of a given
company with regard to such measures as liquidity, performance, profitability, leverage and
growth, on an absolute basis and by comparison to other companies in its industry or to an
industry standard.

Comparative Analysis: Comparative analysis is a valuable tool for highlighting differences

between the subject company’s historical performance and industry averages, pointing out
relative operating strengths and weaknesses of the subject company as compared to its peers,
assessing management effectiveness, and identifying areas where the company is
outperforming or underperforming the industry.
Forecasting & Valuation

Forecasting company performance—can be viewed from two perspectives:

The economic environment in which the company operates and

The company’s own operating and financial characteristics

Forecasting require sound understanding of the following factors:

Business Model of the Company

Operating cycles

Revenue patterns and factors affecting growth rate of revenue

Cost structures

Operating margins

Capex requirments

Forecasting can be done by two approaches:

Top-down forecasting: This approach moves from international and national

macroeconomic forecasts to industry forecasts and then to individual company and asset
forecasts.

Bottom-up forecasting approach: bottom-up forecasting approach aggregates forecasts

at a micro level to larger scale forecasts, under specific assumptions.

In general, valuer integrate insights from industry and competitive analysis with financial
statement analysis to formulate specific forecasts of such items as a company’s sales,
earnings, and cash flow. Valuer generally consider qualitative as well as quantitative factors
in financial forecasting and valuation. For example, a valuer might modify his or her forecasts
and valuation judgments based on qualitative factors, such as the valuer’s opinion about the
business acumen and integrity of management, and/or the transparency and quality of a
company’s accounting practices. Such qualitative factors are necessarily subjective.

VALUATION: Before staring valuation valuer is required to select appropriate valuation as

considered relevant under the facts and cases of each valuation assignment. Absolute
valuation models and relative valuation models are the two broad types of valuation models
that incorporate a going-concern assumption.

Calculation of Free Cash flows: In valuation first and foremost task is to calculate the cash
flows. The cash flows are calculated either by applying Free Cash flows to equity or free cash
flows to Firm.

Cash flows to Equity: These are the cash flows available to the equity holders of the subject
after deducting all the operating expenses. FCFE can be calculated as follwos:

Net Income after Tax

Plus Depreciation and other Non-Cash Charges

Less Incremental non-cash debt free working capital

Less: Incremental Capex

Plus: New Debt Issue

Less: Debt Repayment

Equals: Net Cash flows to Equity

Cash flows to firm or Invested Capital: It is a debt-free model in the sense that all interest
and related debt capital is removed. The value determined by this method is invested capital
which is typically interest-bearing debt, capital leases and equity.

Net Income after Tax

Plus Post Tax Interest

Plus Depreciation and other Non-Cash Charges

Less Incremental non-cash debt free working capital

Less: Incremental Capex

Equals: Net Cash flows to invested capital

Cost of Capital: In cash flow based valuation the cash flows are discounted by appropriate
discount rate in order to get the present value of the cash flows. A discount rate reflects the
compensation required by investors for delaying consumption generally assumed to equal the
risk-free rate—and their required compensation for the risk of the cash flow. Generally, the
discount rate used to determine intrinsic value depends on the characteristics of the subject
company. Several methods are available to calculate the cost of capital or discount/cap rate
for a specific investment. Some of the more common methods include:

Capital Asset Pricing Model: The CAPM is derived from the capital markets. It attempts to
provide a measure of market relationships based on the theory of expected returns if investors
behave in the manner prescribed by portfolio theory. Risk, in the context of this application,
is defined conceptually as the degree of uncertainty as to the realization of expected future
returns which can be divided into three segments, maturity risk, systematic risk and
unsystematic risk. The CAPM model is based solely on quantifying systematic risk because it
assumes that prudent investors will eliminate unsystematic risk by holding large, well-
diversified portfolios. Formula for CAPM Model is

Ke= Rf + β*Rm

Internal Rate of Return: The internal rate of return (IRR) on an investment is the discount
rate that equates the present value of the asset’s expected future cash flows to the asset’s
price—that is, the amount of money needed today to purchase a right to those cash flows. In
a model that views the intrinsic value of a common equity share as the present value of
expected future cash flows, if price is equal to current intrinsic value—the condition of market
informational efficiency—then, generally, a discount rate can be found, usually by iteration,
which equates that present value to the market price.