Advanced Valuation Issues EV Calculation : Intrinsic Value vs Market Value

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What does it mean? Many believe that Enterprise Value calculation in DCF is unrelated to Relative or Comparable Valuation. The process of calculation is in fact perfectly linked! This is particularly useful when handling anomalies or tricky items. The explanation below aims to decode the link between the two approaches! This may be used as How-to guide on item treatment in each approach.

EV Calculation under the DCF Approach

Step 1 Calculate & Discount i. Free Cash Flows ii. Continuing/Terminal Value = Enterprise Value
Step 2 Less: Non equity Claims (at Fair Value) i. Debt (at Book Value or Fair Value, if traded!) ii. Hybrid Capital (Preference Capital & FCCBs) iii. Contingent Liabilities iv. Restructuring provisions v. Pension & retirement related liabilities/deficits vi. Capital & Capitalized Leases vii. Minority Interest (at Market Value!) Step3 Add: Non Operating Assets i. Excess Cash (at Fair Value) ii. Short term Investments (at Fair Value) Add: Investment in Associates (at Fair/Market Value!) = Equity Value (Intrinsic/Fair Value of Equity)

EV Calculation when using Comparables

Step 1 Get Diluted Market Value of Equity
Step 2 Add :Debt & Other Forms of Capital at Market Value (if unlisted, derive Fair value!) Step 3 Less: Non Operating Assets (Often called Cash & Cash Equivalents)

Rationale
EV calculation, under a Market based approach is a mirror image of the Enterprise DCF approach! Secondly, Fair Value as defined by DCF, measures Intrinsic Value of the firm based on future fundamental performance of the firm. While Fair Value under Comparables approach starts with the presumption that the Market is right in determining Fair Value and hence starts with Market Value itself, only to test it later through a peer comparison!

Advanced Valuation Issues EV Calculation : What should EV include?

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Should Enterprise Value include Excess Cash, Marketable Securities and Investment in Associates? It is popularly believed that Enterprise Value should not include these items. However, they must be included in Equity Value. However, Equity is a part of the Enterprise and hence such items are a part of the Enterprise Value as well!

EV should include Excess Cash

Under the Mckinsey DCF Approach, Step 1 i.e.
Present Value of Free Cash Flows from explicit forecast period + Present Value of Continuing value (Terminal Value) = Value of Operations Where, Value of Operations Enterprise Value. Enterprise Value = Value of Operations + Excess Cash & other non-operating assets

Explanation
Q. If Cash is paid out as part of EV wont you get it back ? Is cash a part of Value ? A. It is Excess Cash and not cash, that we are talking about. Cash has two components a) Operating & b) Excess. Operating Cash must be accounted for in Operating working capital (incorporated in FCF itself!). Suppose, the company had no plans for such scenarios. Why didn't it pay out all of it as dividends? The Excess Cash may have been kept aside for a rainy day to be used in times of a liquidity crisis, or for expansion or diversification needs. A buyer simply cannot strip the Balance Sheet of Excess Cash (while it is done in some LBO transactions!), if the buyer were to strip it of cash, it would have to pump in the same amount eventually! The Negative EV phenomenon is a clear display of a fallacy in the traditional EV concept as it does not reflect Acquisition Cost (the very reason why EV is calculated!)

Analysis
Excess Cash belongs to Equity holders. As Excess cash is, what remains after making payments to all other claimholders! In times of profits however, if such Cash is not stored the company may have a liquidity crisis in bad times, or may have to raise extra funds (at higher costs) for expansion or diversification needs Investors, will reward those companies that use Excess Cash Well, thereby increasing the Market Value. Basically, Excess Cash, Profit from Investment in Associates etc. do create Value for Equity (which in turn is a part of the Enterprise). Stripping a company of cash is a temporary solution which will eventually reverse!

The approach suggests, only after Excess Cash & Marketable Securities are added, is the true Value of the Firm/Enterprise revealed! Else the value of the firm is based on Operating activities alone and will hence, always remain undervalued! To prove the point, several leading companies with Excess Cash like Hero Honda, Infosys, Hindustan Unilever etc. have Created Value from nonoperating assets as well! The same holds true for Investments in Associates as well, it too creates value for Shareholders and hence increases Value of Equity which in turn increases Enterprise Value!

Advanced Valuation Issues EV Calculation : What should EV include? Contd

Explanation
Excess Cash, Marketable securities, Investment in Associates and other assets whose Value has not been captured in Free Cash Flow & Terminal value Calculation

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Equity Value

Enterprise Value

Under the Enterprise DCF approach, while calculating Free Cash Flows and subsequently Terminal Value, Non Operating items were deliberately excluded. This is because such items by nature, are unrelated to the companys operations and hence difficult to forecast. Hence, determining their Present Value is a fairly difficult task. They are hence added back to the Value of Operations on a book value basis. Secondly, the discount factor to determine present value of such Free Cash Flows should be the cost of generating them The WACC. The Weighted Average Cost of Capital is the minimum expected return of all capital contributors i.e. Debt, Equity, Hybrid etc. on a weighted average basis). Implying that, WACC must also include the cost of funding non-operating items.

Excess Cash, Marketable Securities & Investment in Associates Add Value to Equity, which in turn is a part of Enterprise Value. Hence such items should be a part of Enterprise Value!

Q. Usually, when non-operating items are significant it would be worthwhile to value each such asset separately (often called SOTP). Instead, what if we could make a modification in the Free Cash Flow calculation to include such items as well, would it yet be consistent with the principles of the Enterprise DCF approach? A. Absolutely! As WACC anyway includes cost of all funding sources irrespective of whether they are deployed in operating or nonoperating assets!
Q. Now, wouldn't the EV include Excess Cash & non-operating assets? A. Yes, of course!

Advanced Valuation Issues EV Calculation : Bottom-Line

Approach 1: Popular Approach
Step 1 Calculate & Discount i. Free Cash Flows ii. Continuing/Terminal Value = Enterprise Value Step 2 Less: Non Equity Claims1 (Rs.1,500Crs) net of Cash & Cash Equivalents (Rs.500Crs) Step 3 Add: Investment in Associates

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Illustration
Step 1 i. Rs.1,000Crs ii. Rs. 2,000Crs = Rs.3,000Crs Step 2 Less: (Rs.1500- Rs.500) =1,000Crs Step 3 Add: Rs.1,500Crs

Approach 2: Mckinsey Approach

Step 1 Calculate & Discount i. Free Cash Flows ii. Continuing/Terminal Value = Operating Value Step 2 Add: Excess Cash, Excess Marketable Securities & Investment in Associates = Enterprise Value Step 3 Less: Non Equity Claims1 (Rs.1,500Crs) = Equity Value (Intrinsic/Fair Value of Equity)

Illustration
Step 1 i. Rs.1,000Crs ii. Rs. 2,000Crs = Rs.3,000Crs Step 2 Less: (Rs.1500+Rs.500) = Rs.2,000Crs = Rs.5,000Crs Step 2 Less: Rs.1,500Crs = Rs.3,500Crs

= Equity Value (Intrinsic/Fair Value of Equity)

1Non Equity

= Rs.3,500Crs

Claims include: Short term Debt, Long Term Debt, Preference Capital, FCCBs (& other convertible debt), Capital Lease, Capitalized Operating Lease, Restructuring Provisions, Retirement related liabilities (deficits),Contingent Liabilities and Minority Interest.

The Sellers Point of View

If Excess Cash & other Non-Operating items are not part of EV, the Seller will simply refuse to part with them! However, the Buyer will eventually replace them with his own funds, essentially increasing the Value of the Enterprise by that much!!

Note
Although, both approaches result in the same Equity Value. The popular approach fails to recognize Excess Cash, Marketable Securities and Investment in Associates as a part of the Enterprise. Resulting in an undervaluation of the Enterprise. It is for this reason that we recommend the Mckinsey approach!

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